Financial institutions at crossroads: Redefining risk management in the age of climate change

In the end, banks become the ultimate receivers of climate shocks, bearing the financial fallout of environmental catastrophes

The recent flash floods in Uttarakhand, India where over 100 people went missing, are just one among thousands of climate-related disasters in recent years. For banks, the impact is direct washed-out assets, loan defaults, and rising credit risk. This is not tomorrow’s threat; climate risk is already reshaping financial stability today. In the end, banks become the ultimate receivers of climate shocks, bearing the financial fallout of environmental catastrophes. Banking risk management is entering a new era. Traditional frameworks built around credit, market, liquidity, and operational risk are no longer sufficient to address the growing complexities of a changing world. 

Among the most disruptive forces is climate risk, which is rapidly emerging as a critical, system-wide challenge. I strongly believe despite increasing global awareness, many financial institutions have yet to fully grasp the gravity of climate risk and its potential to fundamentally reshape the financial landscape. The implications spanning credit risk, operational resilience, regulatory exposure, and reputational damage are often underestimated or overlooked. As climate related disruptions intensify, institutions that delay integration of climate risk into their governance and strategy may face systemic vulnerabilities, eroding stakeholder trust and losing access to global capital markets What makes it distinct is not just its severity or frequency, but its ability to reshape the entire risk landscape demanding a fundamental transformation in how banks assess, manage, and govern risk. 

With my three decades of experience in banking and research across various subjects, including risk management, this article aims to provide an overview of how climate risk is poised to redefine banking risk management, potentially overtaking traditional risk areas in both significance and impact. To start with, as Mark Carney, then Governor of the Bank of England, famously said in 2015, “Climate risk is not just environmental it’s financial.” This statement marked a turning point in how global financial institutions began to view climate change not merely as an environmental concern, but as a systemic risk to financial stability and long-term economic resilience.

Climate risk demonstrate in two main forms:

• Physical risk: Damage caused by extreme weather events such as floods, droughts, cyclones, and rising sea levels.
•  Transition risk: Arising from regulatory, technological, and market changes as economies shift toward a low-carbon future.

For banks, these risks can severely impact:

•  Deterioration of asset quality

Due to physical damages (floods, droughts) or loss of value in carbon-intensive assets.

•  Creditworthiness of borrowers

Borrowers in vulnerable sectors (e.g., agriculture, fossil fuels, real estate) may face default due to policy or physical risks.

•  Operational continuity

Disruptions to branches, data centres, or supply chains due to extreme weather events.

•  Reputation and investor confidence

Increased scrutiny from regulators, investors, and the public; failure to act may erode trust and share value.

•  Constraints in finding new funding avenues and losing global listing opportunities: Institutional investors’ growing focus on the Principles for Responsible Investment (PRI) and Principles for Responsible Banking (PRB) means banks face increasing scrutiny over their climate risk management
•  Green bond pitfalls: Misreading the market and stalling capital flows
•  Negative impact on international trade operations: Climate risk disrupts international trade by damaging infrastructure and complicating compliance with evolving regulations, increasing risks for banks involved in trade finance.
•  Growing exposure to stranded assets and valuations

Long-term assets becoming unviable due to new climate regulations or market shifts.

• Impact on financials: High impact to Expected Credit Loss (ECL), Impairment and Overlays. Adjustments in provisioning due to higher risk exposures, including scenario-based overlays. High probability to increase Probability of Default (PD)
• Risk of losing Correspondent Banking Relationships (CBR-De-risking)

Global banks may terminate relationships with banks that fail to meet climate risk or ESG standards.

• Regulatory and compliance pressure

Increasing demands from central banks, supervisors, and standard setters (e.g., ISSB, NGFS, TCFD).

• Capital adequacy and risk weight adjustments

Capital buffers may be required for exposures to high-risk sectors under evolving prudential rules.

• Rising insurance costs or reduced coverage

Physical risks make it harder and costlier to insure certain collateral or operational assets.

•  Litigation and legal risk

Legal action from shareholders, customers, NGOs or communities for financing environmentally harmful projects.

nMisalignment with ESG and sustainable finance markets

Difficulty accessing green bonds, sustainable finance facilities, or being included in ESG investment indices.

•  Increased cost of capital

Investors may demand a premium or avoid banks not aligned with climate goals

• Financial institutions often face challenges in identifying viable climate mitigation and adaptation projects

This can result in delays in deploying green bond proceeds, leading to opportunity costs from idle funds.

• Displacement or financial exclusion of MSMEs unprepared for climate transition

Small businesses lacking adaptive capacity may face exclusion from credit, higher risk of failure, and informalisation impacting financial inclusion and national economic resilience

•  Talent attraction and retention challenges

Younger workforce and stakeholders prefer working with and supporting climate-responsible institutions.

Traditional risk frameworks are not designed to handle this level of complexity. Climate risk is therefore poised to surpass traditional banking risks in significance. It is not merely an additional category, it is a risk amplifier that simultaneously magnifies credit, market, operational, and liquidity risks.

Climate risk is unique in critical ways:

1. It is systemic: It doesn’t just affect individual borrowers but entire sectors and geographies simultaneously

2. It spans multiple risk types simultaneously:

Climate risk impacts credit risk, market risk, operational risk, liquidity risk, and legal risk all at once, making it multifaceted and complex to manage.

3. It is forward-looking and uncertain: Unlike credit or market risk, climate risk doesn’t follow historical patterns.

4. It is deeply linked to reputation and stakeholder trust: Investors and the public increasingly scrutinise banks’ climate positions.

5. It is intensifying: With every delay in climate action, the risk compounds potentially creating sudden and nonlinear impacts

6. It can amplify social and economic inequalities:

Climate risk disproportionately affects vulnerable populations and businesses (e.g., MSMEs), potentially triggering broader socio-economic instability.

Key emerging changes in banking risk policy

• Climate risk intergration in enterprise risk management ERM: 

Financial institutes are adding climate risk as a core component across credit, market and operational risk frameworks. 

•  Policy updates across risk lifecycle:

Credit underwriting, collateral valuation, and loan pricing now incorporate climate risk factors and ESG premium

•  Capital and stress testing:

Regulators require climate scenario stress tests to inform capital adequacy and resilience planning.

•  Loan pricing is adapting to ESG risk premiums, and CBSL should consider reflecting climate and sustainability factors in its policy rate decisions.
•  Portfolio-level climate risk analysis – Banks should conduct a comprehensive assessment of their asset books and categorise exposures according to the GHG Protocol to identify carbon-intensive assets and align with climate risk management standards.
•  Climate-linked lending and portfolio shift

Banks set targets to cut high-emission exposures and boost green financing, adjusting risk limits accordingly.

•  Skill upgrades for valuators:
• Government and valuation bodies must enhance valuators’ expertise to accurately factor climate risks into asset valuations.
•  Collateral valuation models are to be enhanced to incorporate future climate scenarios, accounting for potential devaluation from physical and transition risks.
•  Rebalancing climate finance: Banks should focus on reducing the acceleration of mitigation finance growth to create more balance, while increasing equity and concessional finance for climate adaptation projects.

If we further analyse the importance, integrating climate risk into the CAMELS framework enhances traditional bank risk management by embedding environmental vulnerabilities into core supervisory metrics. Each component of CAMELS Capital Adequacy, Asset Quality, Management Quality, Earnings, Liquidity, and Sensitivity can be directly influenced by climate-related physical and transition risks. Capital Adequacy must now account for potential losses from climate-exposed loans and stress scenarios. Asset Quality is impacted by the declining value of assets tied to carbon-intensive sectors or those vulnerable to natural disasters. Management Quality reflects how well a bank integrates climate risk into governance, policies, and enterprise risk management (ERM). Earnings can be affected by increased costs from climate compliance or reduced profitability from high-risk portfolios, while climate-related disruptions may challenge Liquidity through sudden funding pressures. Lastly, Sensitivity includes volatility from climate policy shifts, carbon pricing, and investor sentiment toward ESG performance. Embedding climate risks into CAMELS ensures a more resilient and forward-looking banking sector aligned with sustainability goals.

Conclusion

Climate risk is not just an emerging issue, it is a transformational force. As regulatory expectations tighten and environmental realities escalate, banks must shift from reactive compliance to proactive adaptation. Climate risk may not replace traditional risks immediately, but it is already reshaping how credit, market, and operational risks are understood and managed. This demands a change in thinking: policies, skills, and decision-making must evolve. Banks that make climate awareness a core part of their business will be the ones that remain strong in a climate-challenged world. If we fail to act now, climate risk will grow beyond the banking sector and become a national economic issue.

(The writer, holding a PhD, MBA, FIB, FCPM, MCIM, PgBFA, Dip.SF, is a senior banking professional with over 30 years of leadership experience in local and international banks. His expertise spans Retail, MSME, Corporate Banking, Risk Management, and Sustainable Finance, with a strong advocacy for green finance. He served as Vice President of the Association of Banking Sector Risk Professionals, Sri Lanka, where he played a key role in leading industry initiatives. He can be contacted via: [email protected].)