How climate risk could proliferate other types of secondary risks
Through Manoj reddy, Head of BFS Risk & amp; Compliance practice for TCS Nord
The range of enterprise risk management has widened over the past two decades and the past decade which has witnessed the aftermath of a brutal financial crisis and tectonic shifts in business models, customer management and accelerated digital adoption have only meant that the new types of risks have been identified as a significant risk related to the threat they represent to the stability and soundness of the company or to the amount of losses incurred by them. directly attributable. Although credit, market and operational risks are still the basis for calculating regulatory capital, economic capital and ICAAP processes have seen quantification models for secondary risk types and some of these models are becoming de increasingly quantitatively intensive beyond their primitive forms of qualitative approximations. Climate risk is the latest addition to the enterprise risk management space and is one of the most powerful types of risk that has garnered a lot of attention and for good reason as climate change dominates discussions and perspectives in global economic, political, social and financial circles.
Impact of climate risk on types of secondary risk
What makes climate risk so important and visible is its two-dimensional impact of a physical risk (direct impact of climate change) and a transition risk (indirect impact of moving from an existing infrastructure to a more green). To add further to the intricacies of the direct and indirect impacts of climate change, there is the overwhelming possibility of the cross-impact of climate risk on primary risk types and secondary risk types established from a holistic risk management perspective. business. Events related to climate change are likely to have a significant impact on secondary risk types well beyond, which justifies the need to create or improve a dedicated framework to identify, assess, monitor and control them. monitor. Below is a representation of some of the types of secondary risks that are very likely to be affected by climate risk.
Types of secondary risks most likely to be affected
1.Commercial and strategic risk – Strategic risk is the negative impact on the business due to poorly designed and poorly implemented strategies. In the context of climate change, lending policies favoring green finance, launching new products and services for green projects, and investing in green bonds could all be representative of industry-aligned business strategy. Poorly aligned business strategies could lead to increased direct financial losses, higher number of defaults, lowered public perception, etc., although most of these risks end up being perceived as credit or operational risk, It is important to understand that the root cause of these could emanate from a misaligned business strategy and therefore should ideally be attributed as a strategic risk. There needs to be proper consideration given the right product, marketing, location, customer management, and public relations strategy to ensure that it is properly aligned with the direction of the business. industry on climate change. Most banks today might have a qualitative or judgmental approximation of strategic risk, which is likely to be called into question over time, as more losses could be attributed to incorrect strategies at the time. climate change shelter designed and implemented, requiring a more robust strategic strategy. risk management framework.
2.Political and legal risk – The pace of transformation towards green initiatives in a given region or geography will be largely determined by the policies and an enabling business, social and economic environment put in place by the corresponding government and regulatory authorities. Although political risk is factored into business and strategic planning, very few banks have a quantification methodology or framework in place to manage political risk. Legal risk, also known as compliance risk, is largely managed by the compliance management function within banks, and like political risk, it may not have a quantification model. clean. The transition to a greener initiative driven by climate change events will be championed and mandated by government and regulatory authorities, forcing banks to manage political and legal risks in a much more focused and orderly manner.
3.Model risk – One of the main challenges for banks in their efforts to manage the impacts of climate change will be their ability to integrate the large amount of industry data into their internal predictive models. There have been several advancements in model risk management due to regulatory guidance and commentary and most banks today have a strong model risk management function. However, since many more trading results are going to be affected by climate change-related events, we are likely to witness a deviation in model predictions for models that have not been calibrated to include climate change variables, which sets off the alarm. incorrect or inadequate modeling, thus placing more emphasis on managing model risks.
4.Driving risk – Conduct risk is in its infancy in the industry, with most banks likely to have a fundamental framework in place. Funding green initiatives is not expected to be very profitable for banks right now, as the industry will jointly embark on a path to a greener planet. Therefore, it will be difficult for banks to balance long-term strategic sustainability with immediate short-term profitability. Cases in which banks exhibit questionable conduct by charging a premium interest rate to fund green initiatives or creating disincentives for their customers by charging hidden fees, lower returns or inadequate information could be considered driving risk events. Climate change reforms are likely to place more emphasis on the perceived conduct of banks and it is here that a strong conduct risk framework will be invaluable for the bank to avoid possible conduct risk events.
5.Reputational risk – Reputational risk is defined as a financial loss that can be attributed to a compromised reputation. Climate change reforms will require the financial sector and in particular the banks to come together to effect significant change and propel the transition to a greener economy. Thus, increase the perception pressure on banks so that they appear as champions and supporters of green initiatives and safeguard their reputation as a responsible player in this colossal transition. Banks might need to go beyond the existing qualitative approach to reputation risk management to design a tangible framework that can help identify, assess, mitigate and monitor reputational risk, particularly in light of climate change reforms.
6.Third party risk – Third-party risk management has been excluded from operational risk management in recent years. Banks depend on third-party entities for industry data, operational and IT software and services, and infrastructure management. As climate change is about to have a drastic impact on all industries and entities in all sectors, banks will need to pay more attention to their third-party risk management framework and specifically identify their vulnerabilities and dependencies. towards third parties, which will have an impact on their sustainability and business continuity.
Although climate risk is one of the most compelling types of risk that will be added to the field of enterprise risk management as a significant type of risk, it has the potential to proliferate other types of secondary risks. and put them at the forefront of enterprise risk management. as well as. None of the types of secondary risks identified above are new to the financial sector, it is simply that they have been on the sidelines and are likely to be accentuated by events related to climate change. There is already an encouraging level of awareness and anticipation regarding the obvious impact on primary risk types, but banks that can identify, understand and analyze the impact on their secondary risk types ahead of the curve are likely to make the transition with fewer pitfalls in their journey. towards a greener planet.