Risk Management and Sustainability
FS-UNEP Centre / 9 September, 2020
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Sustainable Finance Expert & Researcher
Menglu Zhuang is a sustainable finance expert at the Frankfurt School-UNEP Centre and a researcher at the Frankfurt School faculty. Her role is to research in sustainable financial topics and manage the content development of educational programs on the topic of sustainable finance.

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Risk management has become increasingly important as global uncertainties surge. Many factors play a role in the development of Covid-19 pandemic and in that of climate change. Exactly how severe the negative consequences these events will have on the society and how they will hit the economy are unknown. Despite these uncertainties, it can be assumed that if the risks are not well analysed and managed, there will be worrisome consequences in the near future.

Last year I was able to expand my risk management knowledge at the Frankfurt School through the Certified Expert in Risk Management (CERM) course. I received the certificate without the intention of becoming a full-time risk manager: the motivation to learn more about this in my spare time is, in my opinion, a holistic understanding of risk management is essential for solving some of the important problems in sustainable finance (in particular for the development of technical tools).

A risk management view of sustainability

We can view sustainability through various lenses. One possibility is to look at sustainability from the perspective of risk management. This is particularly helpful when it comes to climate-related financial risks. The Bank of England is considering stress tests for banks with regard to the effects of climate change. This signals that risk-management related measures to address climate-related challenges could emerge from regulations. In addition, as suggested by Kunreuther et al. (2013), a risk-management perspective could be helpful as it would allow for a better examination of a wide range of possible outcomes and the uncertainties surrounding their likelihoods.

By looking at the various classical risk categories and what impact climate-related risks can have on them, we quickly see the close interlinkages:

  • Capasso, Gianfrate & Spinelli (2020) provides evidence that carbon-intense firms are perceived to be more likely to default. However, due to many unsolved challenges, carbon and climate-related risks have not yet found their way into the conventional management framework of credit risks.
  • The physical risks of climate change, once materialised, could have devastating effects on the operation of the banks. To manage operational risks, contingency and recovery plans could be designed for this purpose.
  • Banks that have poor sustainability practices or lend extensively to non-sustainable firms could suffer financially from reputation risks. These risks could be mitigated by integrating sustainability in their business process.
  • Liquidity risks of banks are subject to the supervisory review of central banks since systemic liquidity problems in the financial system may lead to adverse consequences on financial stability. My colleague at FS impact Finance has observed that due to the Covid-19 pandemic, there are cases where the banks’ clients are not able to service their debt, turning credit risks into liquidity risks as banks and microfinance institutions slowly slip into a liquidity crunch. We can conjecture, that similar situations may occur when climate change hits the financial market.

Stress testing of climate-related financial risks for banks

There is a long history of stress testing for solvency and liquidity risks in banks. Many financial regulators are keen on knowing more about potential implementation methods. Besides the Bank of England, the German Federal Financial Supervisory Authority (BaFin) has recently issued a Guidance Notice on Dealing with Sustainability Risks, considering issues on internal stress-testing. Battiston et al. (2017) conducted a climate stress testing on EU banks. This demonstrates the possibility of analysing climate policies by means of stress tests of financial institutions at macro level. However, the key question to understand is how to apply this at a micro level to individual banks. Today, this is even more challenging as we face a new global risk, the pandemic. We can expect that the stress-testing of sustainability, as well as the risk management in general, will go through serious changes in order to capture all new risk factors and respond to the new challenges.

Several words on the Certified Expert in Risk Management

For people who are interested in taking the course: I learned the risk management “language” and the technical tools commonly used in financial institutions. It covers the major types of risks: credit risk, operational risk, interest risk, foreign exchange risk, and liquidity risk, etc. My personal favourite parts are the maturity gap analysis and liquidity risk management. Though CERM has a traditional risk management focus (less about sustainability risks), I find the course contents rich and helpful.

I am looking forward to combining this knowledge with my research in sustainable finance in the near future.