Why Banks Must Overhaul Credit Risk Frameworks for Climate Resilience

Financial institutions should overhaul credit risk frameworks to address accelerating physical climate risks and insurance gaps, according to a report from the University of Cambridge Institute for Sustainability Leadership (CISL). The proposed framework integrates resilience investments into core credit metrics to improve financial stability and risk pricing.

Gwyn Rhodes, co-author of the report and head of the CISL’s Banking Environment Initiative, stated that physical climate risks will impact all economies. He noted that these risks raise significant questions regarding overall financial stability.

The report argues that current systems make it difficult for companies to justify borrowing for climate adaptation. Investments in measures like flood defenses don’t always increase revenue, which conflicts with traditional bank lending perspectives that prioritize debt repayment through new income.

Did You Know? Flood-related disasters have risen 134% since 2000, a trend the report says current backward-looking credit risk frameworks fail to address.

Why traditional credit metrics fail climate risk

The international Basel framework for managing credit risk relies on historic loan performance data. This backward-looking approach cannot keep pace with rapid climate shifts, according to the CISL report.

Rhodes explained that the current structural setup doesn’t help banks factor in how resilience investments make a company a better credit risk in the future. Instead, banks often see these investments as simply increasing a company’s gearing and debt.

Expert Insight: Samantha Carter suggests that the tension here lies in the clash between short-term balance sheet accounting and long-term asset viability. If banks continue to view resilience only as a cost rather than a risk-mitigant, they may inadvertently incentivize the maintenance of vulnerable assets.

How insurance gaps create bank blind spots

Credit risk assessments typically assume insurance will cover physical climate risks. However, the report notes this is increasingly unreliable as some geographic areas become uninsurable, citing the 2025 California wildfires as an example.

Only 36% of insurers provide explicit incentives for loss mitigation and resilience measures. Nora Pankratz, an assistant professor of finance at the University of Toronto, stated that treating insurance as a given creates blind spots on bank balance sheets.

Pankratz noted that while California regulations offer insurance discounts for wildfire mitigation, the savings are too small to provide a sufficient incentive. She argued that resilience investments make borrowers safer, not just more indebted.

What regulatory steps are already underway

The CISL framework seeks to price both the risks and the opportunities of adaptation. Rhodes stated this could help banks build a business case for lending to customers investing in resilience, which may eventually lead to lower capital allocations because the assets are less risky.

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Some regulators have already implemented supporting measures. The European Union uses an infrastructure supporting factor that allows banks to reduce risk-weighted assets for certain infrastructure loans.

The report also identifies a capital relief pilot run by the Monetary Authority of Singapore and clearer climate risk management guidelines provided by the UK’s Prudential Regulatory Authority (PRA).

Rhodes suggested that further standardization would allow banks in different jurisdictions to better benchmark their resilience against peers. He is currently seeking input on the framework from additional regulators and banks.

Frequently Asked Questions

Why is the Basel framework considered inadequate for climate risk?
According to the report, the Basel framework relies on historic performance data, which is a backward-looking perspective that cannot respond to the current pace of climate shifts.

What percentage of insurers incentivize resilience measures?
The report states that only 36% of insurers provide explicit incentives for resilience measures and loss mitigation.

Which regions are already testing capital relief or risk-weighted asset adjustments?
The European Union uses an infrastructure supporting factor, the Monetary Authority of Singapore is running a capital relief pilot, and the UK’s Prudential Regulatory Authority is providing clearer guidelines.

Do you believe financial institutions should prioritize long-term resilience over traditional revenue-based lending metrics?