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A comprehensive climate framework can help lenders comprehend possible climate change impact on SMEs

Sustainability for MSMEs: Banks should develop a comprehensive framework that integrates climate risk assessment into their overall risk-management processes, such as capital allocations, loan approvals, portfolio monitoring and reporting.

Sustainability for MSMEs: Businesses of all sizes across the globe are facing an increasing level of climate-related risks from a growing number of extreme weather events, including floods, forest fires and cyclones. A worldwide study published by the Yale School of the Environment found that between 1980 and 1999, there were 4,212 natural disasters, claiming 1.19 million lives and causing $1.63 trillion in economic losses. However more recently between 2000 and 2019, these figures rose significantly to 7,348 major natural disasters, resulting in 1.23 million fatalities and $2.97 trillion in global economic losses.

As these extreme weather events continue to become more frequent over time, synergies between climate risk and financial resilience also appear in sharper focus. These climate-related financial risks, including both physical and transition dangers, have the potential to dramatically impact a bank’s loan book and overall performance, whilst also affecting several key sectors of the economy.

Therefore, lenders should implement their own best practices when it comes to climate risk assessment, management and monitoring. A few best practices are outlined below:

Establish a dedicated climate risk management framework: Banks should develop a comprehensive framework that integrates climate risk assessment into their overall risk-management processes, such as capital allocations, loan approvals, portfolio monitoring and reporting. Incorporating climate data into risk models enhances banks’ ability to assess and mitigate climate-related risks effectively.

In addition, a comprehensive climate framework enables lenders to better comprehend the possible impact of climate change on SMEs’ operations, supply chains, and financial stability, which has been a challenge due to the lack of accurate and comparative data on SMEs’ ESG performance. Banks would be encouraged to increase lending towards identified high-growth sustainable sectors as well as approve new loans of businesses including SMEs operating in these sectors.

Enhance data and technology use: Banks often lack the technical skills required for climate risk management and should therefore invest in leveraging data and technology. To increase the granularity of climate risk assessments, banks should measure climate exposure not just by portfolio but also at the transaction level.

As a result, lenders need to evaluate multiple data sources and model them in various scenarios to comprehend how their operations and assets are impacted by the frequency, intensity, and duration of climate change. Data and analytics help lenders assess the financial implications of climate risks on SMEs’ operations and profitability and offer tailored financing solutions that align with the specific climate risk profiles of SMEs.

Monitor and build resilience: Banks should regularly monitor and review climate risks and their management strategies. In addition, it is imperative for them to stay informed about evolving climate science, policy developments, and emerging risks to remain adaptive and proactive.

Stress tests that submit portfolios to multiple climate scenarios should be done to evaluate resilience to climate-related shocks. This will enable banks to concentrate on resilient industries and expand lending to businesses—including SMEs—in these industries to meet regulatory requirements as well as enhance their financial performance.

It has therefore become imperative for banks to continuously evaluate and refine their methodologies and processes as new information and data sets become available, and the understanding of climate change evolves. However, regulators have repeatedly emphasised that the tools currently available to banks are insufficient for a thorough evaluation of climate-related risks.

Fintechs are filling this gap by using advanced data analytics, AI, and machine learning, as well as leveraging comprehensive traditional as well as alternative climate-related datasets, thereby improving the precision and granularity of climate risk assessments.

By leveraging fintech solutions, banks can strengthen their understanding of climate risks, improve risk management strategies, and align their business practices with sustainable principles. Consequently, lenders are constantly deciding between buy, build, or partner when it comes to strengthening their financial resilience and managing all aspects of climate change risk.