Addressing Physical Risk Impacts in Risk Management Practices

This case study examines the challenges posed by physical climate risks for banks in managing credit risk and capital adequacy. It focuses on the application of short-term stress testing using return periods to quantify financial impacts. The study reveals that the effects of physical risks escalate non-linearly with scenario severity, particularly affecting counterparties with high exposure and low financial resilience. While portfolio diversification can mitigate some risks, its effectiveness is limited under extreme conditions. The case study emphasizes the need for advanced modeling techniques that integrate physical risk data with credit risk frameworks. It also discusses regulatory developments mandating the integration of climate risk assessments into risk management practices. The analysis includes a portfolio of public companies and utilizes Moody’s-RMS Climate on Demand Pro Return Period Damage Ratios as a scenario analysis tool. The findings highlight the importance of tailored stress testing approaches to enhance banks' resilience against climate-related financial risks.