Climate Risk and Credit Allocation: How Banks Are Integrating Environmental Risk into Credit Decision-Making

ABSTRACT : Climate risk is no longer a far-off environmental issue; it is now a proximate and systemic hazard to financial stability. As central banks, regulators, and investors start to wake up to the consequences of climate change as regards economic systems, banks are being pressed to factor in environmental Risk in credit decisions. Nonetheless, the current credit risk models are not highly sensitive to the intricacy of climate variables, especially in bank lending to corporations. The paper under research examines the ways financial institutions are incorporating environmental Risk, in particular transition and physical risks, in credit allocation, both in terms of methodological advances and institutional issues. A specific focus is made on emerging economies, where vulnerability to climate change is combined with weak regulatory capacity and a lack of data. This paper proposes a flexible model for incorporating climate risk into credit risk analysis and examines its policy implications for sustainable financing and credit portfolio stability.