Integrating Physical and Transition Climate Risks into Bank CreditRisk Frameworks

Abstract

The banking sector faces mounting exposure to climate related losses through both physical risks (e.g., extreme weather, sea level rise) and transition risks (e.g., policy shifts, technology change, market sentiment). Traditional credit risk models capture borrower specific financial metrics but rarely incorporate climate dimensions systematically. This paper proposes a quantitative, multi scale framework that embeds physical and transition climate risk factors into the bank’s credit risk assessment pipeline. The methodology blends geospatial hazard modelling, scenario based macro economic pathways, and borrower level exposure mapping within a stochastic credit risk model. Empirical results using a $5 bn loan portfolio of a European bank demonstrate that the integrated framework improves risk adjusted return estimates, identifies hidden concentration risks, and satisfies emerging regulatory expectations (e.g., TCFD, EU Sustainable Finance Disclosure Regulation).

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