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Climate stress tests coming for banks, fincos

Regulators have been engaging with Jamaica’s financial companies on plans for better stress tests to protect the financial sector from a changing climate, and expects to ramp up on the collection of data towards that goal, a new report shows.

There is a concern that rising storms and other natural occurrences linked to a changing climate, could impair the asset values of the portfolios managed by fincos, which stand at more than $1.5 trillion and put pressure on which have a similar amount of deposits in their custody.

The December 2023 research paper titled Climate-Related Financial Risks in Jamaica was drafted by Cambium Global Solutions with contribution of representatives from the Bank of Jamaica, Financial Services Commission and the Jamaica Deposit Insurance Corporation.

Starting in early 2024, the BOJ as the lead regulator, plans to enhance its data collection and reporting on climate-related financial risks. It will also establish reporting requirements for financial institutions by the end of June, the report stated.

The BOJ intends to conduct its first internal climate stress test of the financial system by December 2026. But it also wants financial entities to do their own climate tests over the period using guidelines to be provided by the central bank.

“These actions reflect the BOJ’s dedication to enhancing its preparedness for climate-related systemic risks,” the report said. “The overall goal for this commitment is the preparation of a consultation paper by the end of 2026” and development of a “standard sound practices related to the integration of climate-related financial risk into financial institutions risk management frameworks by the end of the third quarter of 2027”.

The Bank of Jamaica first indicated it would be incorporating climate change into its supervision of the financial system and improving its oversight of climate risks two years ago. Its Financial Stability Report 2021 incorporated a climate-related scenario.

The stress tests to come represent phase two of a project that began in 2022. The first phase was focussed on preparing the regulator for the new area of regulatory supervision. The central bank’s financial greening initiative was supported by Agence Française de Développement, a donor agency based in France.

Last year, at a workshop with financial companies, the central bank asked for feedback on what the priority should be in averting risk associated with the changing climate. From a diverse range of responses, “the top two items were consistently on climate stress testing and climate disclosure,” stated the report.

Those consultations came in a year of rising temperatures, indicating that climate risks are growing. Last year was the hottest on record, spawning heatwaves over the summer, and scientists predict more violent climate-induced weather by 2050.

Jamaica is susceptible to storms and other natural disasters, and financial regulators have identified various threats affecting credit risk, market risk, liquidity risk, operational risk and underwriting risk.

The 11 banking institutions hold assets of $2.6 trillion, equivalent to about 90 per cent of Jamaica’s total economic output or GDP, and deposits of $1.63 trillion; while another 29 financial securities dealers tracked by the FSC have $1.56 trillion of assets under management.

Currently, many institutions are at the “beginning of their climate journeys”, but a significant number plan to enhance their capabilities over the next 12 months, the report stated.

“Few organisations have a dedicated climate team or have engaged third parties for climate support,” it indicated.

Half of the securities dealers have sustainability goals, but they are typically connected to the “their own operations rather than to their wider financial footprint”.

Ignoring climate risk can make firms financially vulnerable. For example, the destruction of assets arising from a weather disaster results in reducing the collateral available to secure loans; and makes it riskier for lenders to extend credit to borrowers. Also, borrowers face income disruption which can lead to higher bad debts.

The three sectors considered most exposed to physical hazards are tourism, agriculture, and real estate.

Governments around the world under an agreement called the Paris Accord are keen to reduce carbon emissions, which is the main cause of rising temperatures.

The transition to a low-carbon economy will, however, result in the depreciation of certain carbon-producing assets, such as fossil fuel investments. Financial firms that have exposure to these industries or assets face significant credit risks, the report stated.

“Lenders that have extended credit to companies operating in carbon intensive sectors may find themselves facing defaults or repayment difficulties as the value and profitability of these assets decline,” it stated. “Large, stranded assets can undermine the financial stability of both borrowers and lenders. On an individual level, energy inefficient properties may pose credit challenges as higher energy prices cut into income and make repayment of outstanding debts more challenging.”

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