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Head of domestic markets at the Reserve Bank of Australia (RBA) Jonathan Kearns gave a speech to the Credit Law Conference in Sydney this week, outlining the various risks to the financial system posed by the ongoing threat of climate change.
Speaking on Wednesday (24 August), Mr Kearns warned that “climate change can significantly affect the prices of assets if it reduces future cash flows and makes them more volatile”, as well as affecting the value of asset security for loans, leading to borrowers potentially being unable to meet their repayments to their lenders.
Along with this, he stated that climate risk may impact on borrowers’ incomes that could lead to more losses for lenders if the ability of borrowers to make repayments on households or businesses is impeded.
He outlined that banks have “less experience” modelling the financial impacts of climate events and more needs to be done to mitigate and manage these financial risks.
While most mortgages have a “shorter effective life” because the borrower refinances, moves or pays off the loan early, Mr Kearns stated that borrowers may have fewer opportunities to refinance or upgrade their properties “if climate change makes a home’s location less desirable”, significantly decreasing the home’s value in the process.
“The lender may then find that the loan on that property has a much longer realised maturity, and the collateral backing the loan has a lower value,” Mr Kearns said.
Further challenges may present themselves in regard to the borrower being required by lenders to insure their property.
This could present a problem due to insurers being less likely to want to insure a property that has been built on low-lying flood-prone areas, for example, or where the cost of insurance has drastically increased.
“If climate change means a home isn’t insured, then lenders could find that damage from flood, storm or fire results in the collateral value being significantly lower, and so their expected loss-given-default on climate-impacted properties is much larger,” Mr Kearns continued.
He summarised the speech by stating that climate change can have “a significant impact on the structure of the economy, and the pricing and return on assets”, having implications for the efficiency and stability of the financial system.
“It is critical for central banks and financial regulators to carefully analyse and respond to climate-related risks,” Mr Kearns concluded.
“These are complex issues and our understanding of how best to respond will evolve over time.
“But it is critical that financial market participants and regulators act now to best manage the financial risks and facilitate the associated opportunities.”
Research published by CoreLogic in March 2022 cautioned that increasing storm surges and coastal erosion would threaten $25 billion in residential property, with expected knock-on effects for the mortgage industry.
The report was based on a freshly developed coastal risk score at the time that measured the potential impact of climate change over time.