Not so Magic Realism: A climate stress test of the Colombian banking sector

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Flood in the state of Córdoba, Colombia.
Photo: Jairo Bedoya / World Bank

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What are the implications of severe flood events on the Colombia banking sector? And how are loans affected by an abrupt decarbonization of the economy?  With losses associated with climate-related risks increasing globally and scientists warning that unprecedented changes lie ahead, these are important questions for central banks and prudential supervisors.

In a new report, the World Bank and the Financial Superintendence of Colombia, the financial supervisor, examined different scenarios and their potential effects on the Colombian banking sector. This represents the first comprehensive climate-risk stress test in an emerging market.

The report identifies and assesses several climate-related risks in the Colombian banking sector and develops innovative approaches to conduct basic stress tests for climate risks in emerging markets. We focus on risks that are most relevant in the Colombian context, such as large-scale floods and delayed policy action related to decarbonization.


Flood and decarbonization scenarios

Our flood risk analysis focuses on riverine floods from heavy rainfall.  Severe floods have historically been related to La Niña – a recurring weather phenomenon in the Pacific Ocean that is expected to increase in strength due to climate change.

We investigate scenarios of different intensity of flooding and at different points in time. With loan losses for Colombian banks ranging between 0.2 percent of total assets for the least vulnerable banks to 2.2 percent for the most vulnerable ones, these scenarios point to the relevance of timely climate adaptation and sophisticated land-use planning. Further improvements to insurance should also be considered.

Our transition risk analysis focuses on medium-term decarbonization scenarios, based on GHG reduction targets that have recently been increased from 20 percent to 51 percent by 2030 – constituting one of the most ambitious targets in the Latin America and the Caribbean region. We model impacts at a detailed sectoral level, capturing both the direct effects on carbon-intensive sectors, as well as indirect effects on firms along the supply chain.

We find that, in an adverse scenario combining a high GHG-reduction target with delayed implementation of policies, aggregated loan losses for Colombian banks could range between 0.2 percent of total assets for the least vulnerable banks and 2.7 percent of total assets for the most vulnerable ones. Such adverse scenarios could be avoided, however, through timely and coordinated action by all stakeholders involved, including banks.


Greening the financial system

This stress test draws from the work of the Network for Greening the Financial System (NGFS), which is a global group of central banks and regulators working on managing climate-related risks and mobilizing capital for green and low-carbon investments.

Our scenarios align with the classification adopted by the NGFS, distinguishing between orderly and disorderly transitions and looking at flood risks in the future lower and higher global warming outcomes. Several NGFS member countries have published climate-risk stress tests, and more are working on them.

Working in an emerging market context comes with challenges, as typically there are fewer data sources and models available to perform the analyses. We have dealt with this by developing tailored data, by leveraging locally available models, and by combining data from a range of other sources – including from national expert bodies and output from global models.

Nevertheless, some assumptions were necessary and results of our assessment should thus be interpreted with some caution. Given the explorative nature of climate-stress testing, results are not intended to identify capital shortfalls or to provide pass or fail outcomes for banks.

With respect to the broader development agenda, the World Bank is globally expanding its technical assistance on greening financial sectors.  This includes several areas of expertise on climate risk assessments, financial supervisory guidance, disaster risk finance, and green finance.

We are committed to sustainable development with the ultimate aim of better aligning capital allocation with the goals of the Paris Agreement while at the same time making economies more resilient to natural disasters and changing weather patterns.

Authors

Henk Jan Reinders

Financial sector consultant

Martijn Regelink

Experto senior del sector financiero

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