Climate Risk Management in Banks – Mortgage Lending, Affordability, Insurability, and the Role of Covered Bonds in Europe

This article follows our previous blog post: ‘Part 1 | Climate risk is forcing banks towards integrated risk management software’, and is one of many of our climate risk related articles.

In this article, we’ll cover what banks should consider whilst trying to understand the repercussions of climate risk, specifically some of the wider ramifications related to mortgage lending. For many European banks, mortgages constitute a large part of their lending. Many banks also place some of their mortgages in designated covered pools, from which they may issue long term covered bonds. This exposes banks to credit, liquidity, and market risk over time, as discussed below.

In this article we will cover the following topics:

• How does the exposure manifest?
• Why are the concepts of affordability and insurability so important?
• What is the role of covered bonds in Europe?
• So, what can banks do and how should climate related risks be managed proactively going forward?

How does the exposure manifest?

In Europe, mortgage loans are typically originated with the intent to hold them to maturity. Thus, these same long-term assets could expose banks to climate risk over time. Policymakers and supervisors alike have understood the potential materiality of how climate related risks might affect banks going forth, thus requiring banks, small or large, to conduct an idiosyncratic analysis of their potential exposure. As banks could be exposed to significant concentration risk, there is a need to conduct an idiosyncratic analysis of the potential exposure at risk.

Concentration risk could manifest itself as regional exposure to real estate, that could be at risk of riverine flooding, sea level rise or wildfires. Thus, the physical collateral pledged against individual mortgage loans could be at risk of flooding or wildfires, so literally under water or on fire! Wait a second, all those houses are insured right? So it’s the insurance company who’s on the hook, no?

Banks have historically relied on the fact that their collateral is insured and may have taken for granted this as status quo. However, two growing concerns for banks, policymakers and supervisors alike are the concepts of affordability and insurability.

Why are the concepts of affordability and insurability so important?

As physical risks rise regionally, this may significantly impact insurance premiums, affecting the mortgage servicing ability of individual households negatively. This is the affordability part.

Insurability could be seen as the next step when insurance companies deem the underwriting risk for certain exposures as too high. Select households might become “mortgage prisoners” as houses become un-sellable because they are un-insurable.

So, banks really need to conduct an idiosyncratic analysis to assess any concentration risk they might be exposed to and how changes in affordability and insurability could impact them. Once an analysis reveals that there are loans and underlying collateral at risk, it becomes imperative to understand the transmission channels of how this risk could impact the bank. How does lower household wealth and lower property values cascade through the financial system affecting the bank’s balance sheets, income statements and key risk metrics alike?

In terms of transmission channels and how lower household wealth and property values might affect a bank, the first thing that comes to mind for most people is probably through loan losses and impairments. But the buck does not stop there. Unfortunately, there are obvious second order effects that come into play.

What is the role of covered bonds in Europe?

To understand these potential effects, we need to understand the huge role covered bonds have assumed as part of the European financial system. Covered bonds are the primary whole-sale funding tool for mortgage lenders, but at the same time they are a core constituent of many banks HQLA (High Quality Liquid Assets) portfolios. Lower property values, would lead to higher LTVs (Loan To Value), which in turn could affect:

• Market values of banks HQLA holding, leading to market losses;
• Which would reduce the liquidity value of those portfolios, reducing the LCR metric.
• Higher LTVs could lead to negative collateralisation effects for their covered pool forcing banks to increase available collateral.
• New issuance of covered bonds, would likely happen at wider spreads, leading to an asymmetric stress on NIM (Net Interest Margin), thus impacting NII and retained earnings over time.

This may be a somewhat simple and crude example, but still relevant for European mortgage lenders nevertheless – it illustrates how climate risk can cascade and morph through the bank, impacting credit, liquidity, and market risk at the same time, having an impact on both prudential and internal metrics and constraints.

So, what can banks do and how should climate related risks be managed proactively going forward?

1. Banks need to identify the risks as much as the transmission channels.
2. Supervisors have urged banks to develop tools and methodologies for scenario analysis purposes, to capture the multitude of effects. Lack of relevant historical data and the fact that this is a forward-looking risk that may go beyond the normal business planning and stress testing horizons, further exacerbates the need for good scenario analysis tools.

MORS Software is a pioneer in the field of scenario analysis for both stress testing and financial planning purposes. With our unique transaction-level based data integration, MORS Software is able help our clients monitor and manage climate related risks transparently, as the impact on credit, liquidity and market risk alike can be measured accordingly in an interconnected way in the same system, based on the same data.

Would you like to know more how MORS Software can help you on the road to a sustainable future?