As weather events and ESG investments accelerate, risk teams have grown accustomed to accounting for climate-related exposure. Financial institutions and other businesses are beginning to incorporate that information into other aspects of operations, like fund transfer pricing, credit assessment and more.
In the contemporary era of climate change, the financial services industry is seeing several transformations across its product and service lines, and almost all financial services firms are focused on establishing or enhancing their environmental, social and governance (ESG) initiatives if not already contributing global climate change efforts.
Though green financing through issuance of green or sustainability linked loans and bonds are at the forefront of the climate change transformation, it is important to augment the supporting functions in the background, enabling green financing to be more climate sensitive in its risk assessment and pricing. One such function is fund transfer pricing (FTP), eventually flowing into financial product pricing.
Enhancing Fund Transfer Pricing Frameworks
FTP enables risk-based profitability assessment of lines of businesses, products and other entities. Though there are efforts to incorporate climate risk into the overall enterprise risk frameworks of financial institutions, it still needs to be explicitly factored into the FTP framework, at least in the near term as it evolves and penetrates deeper into the operational activities of banks and financial institutions.
FTP frameworks have evolved over the years from being a single pool to matched maturity and from primarily passing on the reference rate of wholesale funds to incorporating a spread for interest rate risk, liquidity risk and liquidity contingency. Also, the LIBOR transition has necessitated financial institutions to explore and rebuild funding and FTP curves with alternate reference rates.
Fundamentally, FTP frameworks should factor in risks that cannot be solely attributed to a specific business to ensure it is centrally managed and charged at an enterprise level. The impact of climate risk needs to be viewed in a multi-dimensional manner.
For instance, climate risk for a bank should not be simplified to be only viewed as a depleted or progressively depleting credit worthiness of a borrower due to climate sensitivity. Rather, it should be viewed more holistically as potential losses that a bank could be exposed to due to damage to its own physical assets, disruption to its services or other resources due to physical risk on account of adverse climatic events or transition risk in from switching to energy efficient branches and infrastructure.
Hence, there is a case to consider an enterprise-wide impact to a financial institution and its resources from climate change and to factor that into the FTP framework as a climate risk spread that can then be passed on to business units as an augmented fund transfer price on which the line of business spreads and pricing components can be applied. The respective business unit is where the deal- and borrower-specific spread for an attributable form of climate risk can be applied to arrive at the final price for a loan or a credit arrangement.
Also, there are specific lines of businesses in banks which are driving green financing, and they will need to incentivize borrowers through subsidies and differential pricing. Horizontalizing the enterprise-level climate risk charge by incorporating it in FTP frameworks will ensure that there are level playing fields when it comes to profitability assessment among all business units without having to penalize the business units that are at the forefront of climate change transformation.
One approach to achieving this would be to estimate the potential interest subsidy across all green financing lines of businesses and baking it into the fund transfer price to all business units across the enterprise with specific exclusion of green financing lines of businesses that will in eventually bear this charge in their deal-specific pricing. The aptness in climate risk spread being charged to FTP will be progressively achieved with sophistication in data analytics and modeling for quantifying climate risk. For now, it is important for financial institutions to seriously consider its inclusion to circumvent the impact of unaccounted losses in performance and profitability assessment of business units.
Business Unit-Specific Pricing of Green Financial Products
Mortgage business units are expected to propel the transition to green and energy-efficient homes and properties on the retail and consumer banking front. Green mortgages are largely similar in construct to conventional mortgages, with the broad distinction being that the homeowner intends to make the home climate-friendly and energy-efficient. They are also referred to as energy efficient mortgages (EEMs). There are also some lenders offering green loans that are unsecured personal loans where the utility of the loans is largely for environment-friendly improvements.
Since there is very little if any actionable data to factor in climate risk charge through credit scores for individuals, the existing pricing framework are largely expected to be leveraged with some level of subsidization factored into pricing for green mortgages and loans. As the frameworks and methodologies for computing individual ESG scores strengthen, we could see their incorporation into the application scorecards and loan pricing engines even for consumer and mortgage banking.
There is potential to augment the pricing framework for commercial loans, as there is much more actionable data by way of disclosures, score and agency ratings to determine the potential climate risk a borrower might possess. On the commercial loans front, there are green loans, where the loan proceeds are allocated and tracked for usage in green projects. Also, there are sustainability-linked loans, which are still general-purpose loans linked to sustainability performance targets related to things like carbon footprint and greenhouse gas emissions.
Most banks are in the process of augmenting their borrower ratings frameworks with ESG scores or ratings of borrowers to determine the climate-adjusted probability of default, which will determine the credit risk-specific spread that needs to be applied to the price. Even if a borrower is not using a green loan, the incorporation of climate sensitivity into overall credit risk frameworks could mean pricier loans for businesses that are not demonstrating enough on the ESG front. There could be many such direct or indirect impacts on loan pricing as we get deeper into the transition in the years to come.
There is an unprecedented and constantly increasing level of demand for green bonds, largely due to ESG policies and regulatory mandates in certain states and nations. Though green bond markets have been facing challenges around greenwashing and lack of transparency, increasing issuance of green bonds by banks with their regulatory oversight and mature disclosure frameworks is restoring faith in this segment of the bond market.
Putting economics at play, constantly increasing demand for green bonds, coupled with the fact that these bonds fund ESG mandates, means banks can factor in a portion of their potential climate risk losses by way of discounted coupon rates. Also, from a cost of funds perspective, green bonds could be a very good source to help stabilize overall net interest margins (NIMs) for banks that are under pressure for the ESG credit they are extending or will be shortly extending to their customers.
Though the focus of climate change for now has been on the risk it poses to businesses across the spectrum of enterprise risk, it is important as a financial institution to factor in the impact of these risks into the pricing framework for products and services. Most importantly, financial institutions need to closely align their ongoing assessment of potential impact and quantification of the risk and incorporate it into pricing, ensuring more robustness and resilience for impacts from such climate change transformation and continue to provide safety and stability to the financial system.