Two underappreciated climate risk topics: Exposure at default and asset valuation

Sergio Scandizzo and Tony Hughes

EXPOSURE AT DEFAULT (EAD)

Initial efforts to stress test banking operations have focused on the long-term effects of climate change on a static banking portfolio. This approach is consistent with the observation that the near-term effects of warming on financial portfolios are likely to be muted. Those who view climate change as a substantial risk, especially in terms of physical risk, normally concede that the effects are unlikely to be felt within the next decade or two.

The reliance on a static portfolio assumption mirrors the approach taken in routine, annual bank stress testing exercises. In this setting, a deep recession is assumed to occur immediately, meaning that banks have no time to shape their existing exposures to ready themselves for the rigours described by the looming, adverse scenario.

In the context of a three-year stress event, a static portfolio is an entirely reasonable assumption to make. It may be interesting for banks to consider possible dynamic responses to the onset of recession, but the degree of control available to banks is understandably rather limited. They may be able to restrict unutilised revolving credit lines, for example, or decline to originate