Financial sector feedback wanted on climate related guidance

• Tweet

The Reserve Bank (RBNZ) is seeking feedback on proposed new guidance for the financial sector on managing climate-related risks.

Thursday, March 30th 2023, 9:00AM 2 Comments

by Sally Lindsay

Nearly a quarter of banks’ residential mortgages in Auckland are at risk in a one-in-100-year rainfall flood event, data from the bank shows.

RBNZ deputy governor Christian Hawkesby says despite banks’ flood exposure, their capital ratios are resilient to the most severe flood sensitivities.

However, climate-related risks continue to evolve, with the potential to significantly affect the financial system in the future, he says.

“The financial stability risks associated with climate change are significant, necessitating an urgent and collaborative response.”

Hawkesby says the RBNZ is obliged to identify, manage, and mitigate these risks as part of its daily activities.

The draft guidance has been adapted from international best practice to suit the New Zealand context and applies to all of our regulated entities including registered banks, licensed insurers, licensed non-bank deposit takers, and operators of designated financial market infrastructures.

The RBNZ is proposing entities develop their capabilities in climate-related scenario analysis and stress testing.

“It is important for entities to look ahead to a range of plausible future climate scenarios, for example more frequent floods and droughts, in developing actions and targets to ensure that their business model and strategy is resilient,” Hawkesby says.

Submissions to the RBNZ close on June 7th.

Banks calculate mortgage loan losses in flood zones

The RBNZ recently released a 2022 paper on flood risk assessment for residential mortgages written by Rebecca Newman, Jonathon Adams-Kane, and Ken Nicholls.

The trio undertook risk assessments of the biggest banks covering banks’ residential mortgage and agricultural exposures.

The main purpose of these exercises is to support banks to build their capability to identify climate risks and find solutions to the significant data and modelling challenges involved.

In turn, this will lead to more proactive management of climate risk.

The climate stress test required banks to calculate loan loss provisions for mortgages affected by coastal flood zones, taking into account a customer's ability to service the loan and changes to the underlying value of the property.

The rationale was that people whose homes had flooded were likely to come under financial stress, and be unable to make their mortgage repayments, even as the value of their homes fell.

The RBNZ assumed price falls on individual homes could be as high as 30-60 per cent. Since then, house prices have fallen and mortgage rates have risen, making homeowners more vulnerable to the shocks if the exercise was rerun today.

The Reserve Bank says 2.5 per cent of the total dollar value of residential mortgage lending is exposed to the coastal flood zone with 50 centimetres of sea level rise. That rises to 3.8 per cent in a more severe outcome with one metre of sea level rise.

Hawke’s Bay is the region most exposed with more than 10 per cent of homes with mortgages at heightened risk if sea levels rise by 50 centimetres, or 20 per cent if they rise one metre.

The results are consistent with estimates based on a National Institute of Water and Atmospheric Research (NIWA) study that 2.9 per cent of the country’s population and 3.5 per cent of buildings are in the coastal flood zone at 50 centimetres of sea level rise.

Coastal flood exposure is concentrated in certain regions. According to aggregate bank submissions, for 50 centimetres of sea level rise, Christchurch contributes 22 per cent percent of the national exposures at-risk. This is followed by Wellington with 14 per cent of the national total.

Across regions, there are significant differences in the share of mortgage lending on properties that lie within a coastal flood zone. Hawke’s Bay is particularly at risk, with 15 per cent of mortgage lending in the region’s flood zone for 50 centimetres of sea level rise, and almost 20 percent for 1 metre of sea level rise.

In the report, ‘very severe’ property price sensitivity and sea level rise of 20 centimetres aggregate mortgage provisions for the five banks rise to $660 million; more than 45% higher than the 0 centimetre baseline level of $450 million.

Provisions increase to $900 million, double that of the baseline level, at a sea level rise of one metre.

Future effects of climate-related flooding on bank capital are uncertain, but higher provisions reduce bank profitability and capital.

Banks provision on a forward looking basis and will increase provisions if the likelihood of customer defaults increase and/or property values decline.

In the at-risk areas, the probability of default increases due to higher insurance costs, lower rental income from investment property, and lower property prices.

Potential losses on any of these defaulting properties increase due to the fall in property prices which reduces homeowners’ equity and security for the bank. Both of these factors are likely to increase the banks’ levels of provisions.

However, these effects on total provisions are much smaller than the outcomes of the 2022 solvency stress test, which featured a major economic downturn, but are significant for the relatively small amount of exposures at risk.

Insurance at risk

The paper says If owners of mortgaged homes could no longer get insurance, banks would face the risk of losses on existing loans..

Insurers generally issue insurance cover on a 12-month term, meaning that annually they can re-evaluate a policy based on any new information or understanding gained regarding the risks associated with a property or area, or a change in the cost of reinsurance.

A change in the affordability or availability of insurance could trigger a fall in property values, as reduced insurance cover would shift greater risk onto homeowners and lenders. This could occur quickly given the annual insurance cycle.

Other factors that could see a drop in flood-affected property values include greater homeowner awareness and risk aversion when buying a property in a flood zone, lower rental income, a sudden increase in flood zone properties for sale in anticipation of future events, or a reduction in the quality and provision of key infrastructure in flood-affected areas.

Tags: RBNZ

Comments from our readers

Sign In to add your comment