Climate change is no longer confined to the realm of environmental policy; it has emerged as a critical source of financial risk with far-reaching implications for economic stability. Increasingly frequent and severe climate events—such as floods, heatwaves, and storms—alongside the global transition toward low-carbon and sustainable economic models, are reshaping financial markets and credit systems. Banks, as the primary intermediaries of capital, face growing exposure through their loan portfolios, investments, and operational infrastructure. Recognising that these risks can undermine the resilience of financial institutions and trigger systemic shocks, central banks and regulators worldwide are now treating climate change as a core component of their financial stability mandate.
- How Climate Change Affects Banks
There are five main ways climate change is creating financial risks for banks:
- Physical Risks
Extreme weather like hurricanes, wildfires, and rising sea levels can damage homes, farms, factories, and infrastructure. When this happens, people and businesses may lose income or see the value of their property drop — making it harder for them to repay loans. This increases the chance of loan defaults. At the same time, bank branches, ATMs, and digital systems can be disrupted, making it hard to serve customers. Repeated disasters can weaken entire regions economically, leading to bigger losses across a bank’s loan portfolio.
- Transition Risks
As the world moves away from fossil fuels to cleaner energy, some industries — like coal, oil, and heavy manufacturing — may struggle to survive. Governments may impose carbon taxes or stricter pollution rules, and consumers may shift to greener alternatives. Companies that fail to adapt could lose value quickly. Banks that have lent a lot of money to these high-emission industries may end up with bad loans and big losses.
- Liability Risks
More and more companies are being taken to court for harming the environment or failing to disclose climate risks. If a company that a bank lends to gets sued or fined, it might not be able to repay its debts. Even if the bank isn’t directly sued, it can still suffer financial and reputational damage. These legal risks are growing and harder to predict.
- Reputational and ESG Risks
People care more than ever about how companies treat the environment and society. Banks that fund polluting projects can face public backlash, lose investors, or see their borrowing costs go up. While this may not hit the balance sheet right away, poor environmental and social performance can reduce trust and make it harder to raise capital.
- Systemic Risks
If climate change causes large-scale economic damage — like shutting down whole industries or wiping out regional economies — it could trigger a chain reaction in the financial system. Banks are closely linked through loans and investments, so trouble in one area can spread fast. This could lead to inflation, job losses, credit shortages, and even a recession, threatening the overall economy.
- What Central Banks Are Doing About It
To protect the financial system, central banks are taking action to help banks prepare for climate risks:
- Treating Climate Risk as a Financial Risk
Organizations like the Bank for International Settlements (BIS) and the Basel Committee now say climate change must be part of standard risk management. This means banks should include climate risks when assessing credit, market, liquidity, and operational risks — just like they do for other major threats.
- Running Climate Stress Tests
Regulators are designing stress tests that simulate severe climate events — such as sudden carbon price hikes or extreme weather — to see how well banks would cope. These tools help banks evaluate whether they have enough capital to survive long-term climate impacts and prepare for uncertain futures.
- Requiring Clear Climate Reporting
Inspired by the Task Force on Climate-related Financial Disclosures (TCFD), many regulators now require banks to report their climate risks openly. Banks must explain how they manage these risks, what their exposure is, and how climate change could affect their business. Countries like India are beginning to enforce these rules, showing this is becoming standard practice.
- Improving Data and Tools
Better data helps banks understand where risks are. Central banks are helping build stronger systems — using satellite images, climate models, and emissions tracking — to measure how different regions and industries might be affected. This allows for smarter lending and risk management decisions.
- Stronger Oversight Without Major Rule Changes
Instead of changing core capital rules overnight, most regulators are using “Pillar 2” supervision — which lets them review banks’ internal risk assessments. This means banks must identify major climate risks and hold extra capital if needed, based on their specific situation.
- Role of Global Financial Institutions
This approach is consistent with guidance issued by key global financial bodies such as the Bank for International Settlements (BIS), the Basel Committee on Banking Supervision, and the Network for Greening the Financial System (NGFS). These institutions have emphasised that climate-related risks can threaten the safety and soundness of banks and, if left unaddressed, may undermine financial stability. By encouraging the integration of climate risk into governance, risk management, stress testing, and supervisory review processes, they have helped frame climate change as a mainstream prudential concern rather than a peripheral environmental issue.
Conclusion
Climate change is reshaping the financial world. It’s not just about saving the planet — it’s about protecting the stability of banks, markets, and economies. From natural disasters to policy shifts and legal challenges, the risks are real and growing. Central banks are stepping up by making climate risk part of financial regulation. Through stress testing, better reporting, and improved data, they’re pushing banks to become more resilient. While the system is still adapting, these steps mark a turning point — toward a financial future that’s more prepared for the challenges of climate change.
In this sense, managing climate risk is no longer optional — it is central to the modern mandate of banks and central banks alike.
