Financial institutions at crossroads: Redefining risk management in the age of climate change

THE recent flash floods in Uttarakhand, India where over 100 people went missing, are just one among thousands of climate-related disasters in recent years. For banks, the impact is direct washed-out assets, loan defaults, and rising credit risk. This is not tomorrow's threat; climate risk is already reshaping financial stability today. In the end, banks become the ultimate receivers of climate shocks, bearing the financial fallout of environmental catastrophes. Banking risk management is entering a new era. Traditional frameworks built around credit, market, liquidity, and operational risk are no longer sufficient to address the growing complexities of a changing world.

- By Dr. Gishan Illangakoon

Among the most disruptive forces is climate risk, which is rapidly emerging as a critical, system-wide challenge. I strongly believe despite increasing global awareness, many financial institutions have yet to fully grasp the gravity of climate risk and its potential to fundamentally reshape the financial landscape. The implications spanning credit risk, operational resilience, regulatory exposure, and reputational damage are often underestimated or overlooked. As climate related disruptions intensify, institutions that delay integration of climate risk into their governance and strategy may face systemic vulnerabilities, eroding stakeholder trust and losing access to global capital markets What makes it distinct is not just its severity or frequency, but its ability to reshape the entire risk landscape demanding a fundamental transformation in how banks assess, manage, and govern risk.

With my three decades of experience in banking and research across various subjects, including risk management, this article aims to provide an overview of how climate risk is poised to redefine banking risk management, potentially overtaking traditional risk areas in both significance and impact. To start with, as Mark Carney, then Governor of the Bank of England, famously said in 2015, "Climate risk is not just environmental it's financial." This statement marked a turning point in how global financial institutions began to view climate change not merely as an environmental concern, but as a systemic risk to financial stability and long-term economic resilience.

Climate risk demonstrate in two main forms:

Physical risk: Damage caused by extreme weather events such as floods, droughts, cyclones, and rising sea levels.

Transition risk: Arising from regulatory, technological, and market changes as economies shift toward a low-carbon future. For banks, these risks can severely impact: