Risk modeler RMS found the clients of leading banks across the globe would see credit rating downgrades when tested against exposure to normal drought scenarios with a sophisticated drought stress testing tool RMS recently made in collaboration with financial institutions.
RMS worked with leading banks from the U.S., China, Mexico, Brazil and other financial institutions in a project funded by the German government’s Federal Ministry for Economic Cooperation and Development (BMZ) to develop a risk model that would enable greater finance sector resilience to growing risk of drought.
The open source tool stress tested bank loan portfolios under drought scenarios in Mexico, Brazil, China and the U.S., and found that less extreme droughts would cause rating downgrades while extreme droughts could increase loan default losses 10-fold for specific portfolios most exposed to drought impact.
Dr. Yin Hong, Deputy Director of Urban Finance Research Institute, ICBC said; “Water-related risks have become increasingly serious all over the world. As one of the biggest commercial banks in the world, ICBC has spent many years in protecting our portfolios against environmental risk; water risk is one of the most important. We actively participated in this project on water risk as it provides a useful tool to all financial institutions, and will encourage other commercial banks to focus on this risk.”
The stress test showed sectors most affected by drought are water supply, agriculture, and in countries with high hydroelectric energy production, power generation.
However the knock-on impact would see food and beverage production sectors taking a hit, alongside sectors highly sensitive to general economic strength, such as petroleum refining, RMS said.
Denise Hills, Head of Sustainability and Inclusive Business, Itau Unibanco, commented; “The world is facing a changing climate. Brazil’s water crisis in 2015 made us more aware about the impacts and possible loss to companies, the economy and environment. We at Itaú Unibanco are proud to participate in the Drought Stress Testing Tool as we can now measure the effects of water-related crises to our portfolios. Knowledge of the risks is the best way to mitigate them.”
The project measured the credit worthiness of bank loans to improve perception of risk management by giving financial institutions up-to-date and accurate insight into how drought scenarios would impact loan portfolios.
The RMS model was based on the catastrophe modelling framework the insurance industry has used for 25 years.
It examined five different drought scenarios in Brazil, China, Mexico and the US – to model the impact on 19 different industry sectors, the companies in those sectors, and the likelihood that they would default on their loans.
Linda Murasawa, Sustainability Head of Santander Brazil, said the tool would have an immediate impact “in terms of awareness raising and bringing the issue of environmental stress testing closer to mainstream risk management.”
She added, “we consider environmental risk management as an irreversible trend in the financial industry. Participating in this pilot was an excellent opportunity to further foster this agenda and to evolve our understanding of the possible impacts of droughts to our business.”
The finding’s suggest that global banking institutions carry more exposure to natural perils than they are aware, and that they may need insurance or risk transfer to protect themselves against the impacts of such events.