Climate-related physical risks, such as typhoons, floods, and heat waves, will result in considerable damages and losses to the real economy and to the financial sector that provides financing for economic activities. Against this backdrop, the international financial community has been calling for attention and actions to integrate climate-related physical risks into financial decision-making by financial institutions. To manage environmental and climate risks, the primary step is to quantify these risks. However, literature that quantifies the implication of climate-related physical risks for the financial sector is very limited.
We present an analytical framework for measuring the impact of climate-related physical risks on the default risk of bank loans. We applied this method to quantify the increase in the probability of default of mortgage loans for properties in China’s coastal cities, caused by the increased intensity and frequency of typhoons under four commonly used climate scenario defined by the Intergovernmental Panel on Climate Change.
The preliminary findings of this INSPIRE study show that future typhoon events exacerbated by climate change along the coast of China could potentially lead to a considerable increase in the probability of default for mortgage loans, with a possible accumulation of incremental probability of default of more than 5%. This analytical framework can also be applied to many other scenarios of environmental and climate risk analysis for banks if the data required are available, such as impacts of floods and water shortages on credit risk of loans to sectors that are sensitive to such risks.