Risk Assessment and Management
Risk management, as an industry, has undergone distinct phases of change over the last 30 years.
Throughout the 1990s, the driving change was on market risk. The banking sector adopted parametric VaR (Value at Risk) models that effectively and quickly estimated daily changes in market risk across the portfolio, as it was the most appropriate one, given the data available and the computation power at hand. By 2000, historic VaR models proliferated, with Monte Carlo models being adopted by larger banks. This change was made possible by rapid advances in computing capabilities, which caught up with the risk science and enabled timely reporting.
The period between 2000 and 2010 saw credit risk under the microscope, with the market moving from reasonably manual credit assessments to PFE (Potential Future Exposure) coupled with more sophisticated credit rating options. This was a natural consequence of the market risk evolution, which created more advanced trading and lending strategies, and as a result, more complex credit profiles.
The financial crisis of 2008 caused regulators from across the world to look closely at the liquidity risk, which can be viewed as a result of credit risk management within banks. The result has been – increased risk reporting against liquidity stress tests, accounting measures such as CECL and IFRS9, and standard liquidity ratios.
The 2020s is the decade of climate change. In practice, this means that governments are coming together to develop goals and plans to hold global temperature rises to levels where impacts can be managed. Management of these impacts also entails financing adaptation projects across the world. Financing for both mitigation and adaptation must primarily come through the private sector, and as such, will flow through the balance sheets of the world’s banks.
This creates a new risk management challenge for banks. Climate pathways are created by scientists, primarily those working through the Intergovernmental Panel on Climate Change (IPCC). The pathways themselves are described in real-world terms. Costing of these pathways is a role that falls under the Net Greening of the Financial System (NGFS), a body made up of central bankers and economists from across the world. To assess the impacts on their borrowers and credit facilities, banks must translate these pathways and their costs into economic scenarios that can be applied to their books.
While similar to liquidity stress testing and credit risk, climate risk has unique characteristics that must be taken into account. The scenarios must be highly specific and mirror climate pathways. Banks must also have the ability to adjust costs to reflect different speeds in various regulatory regimes. GreenCap provides the capabilities needed to predict these changes in risk capital that will arise from those pathways by representing them in impact terms across industries.
Treating the transitional (coming from policy changes that impact business models) and physical (damage to the economic value of assets as a result of extreme weather events) separately, GreenCap provides analytics that moves from industry to individual loan level. The solution allows borrowers to benefit from early mitigation and adaptation measures but crucially provides the adjusted risk numbers by using traditional, well-established risk measures.
The fourth major evolution in risk management is happening now. Climate change risk management, with GreenCap, leverages the advancements in risk that have happened since 1990, to provide a reliable risk assessment that is designed to use scientific assessment to forecast future credit risk capital requirements.