Climate change is creating operational and strategic challenges for banks globally as governments move towards low-carbon economic models, and as physical climate risks become more acute, according to a recent report.

Banks, according to the report published by Moody’s Investors Service, need to adapt to rapid shifts in the technological, political and regulatory environment, and in stakeholder behaviour, as well as to more adverse climate conditions.

This adds to the industry's other challenges, such as those posed by digital innovation. Banks must apply climate criteria across their lending and investment decisions to take advantage of new opportunities. They must also learn to manage emerging risks as climate change disrupts the economy, erodes corporate revenues, and triggers regulatory changes that may affect bank credit quality.

Carbon transition and physical climate risk alter the cost-benefit analysis of banks' lending and investment options, putting the industry under pressure to integrate climate risk considerations into its strategic decisions, business processes, governance and risk management frameworks. Climate change also affects borrowers’ finances, creating credit risks for banks.

While climate risks are difficult to model, Moody's expects banks to gradually become better at managing and pricing them. Credit risks will be greater for banks that fail to adapt, or in scenarios that require a more rapid adjustment.

Banks will need to invest in building climate expertise, while at the same time facing a growing number of climate regulations. A rapid expansion of banks' low-carbon asset portfolios may increase their exposure to assets whose economic viability is unproven, and they also face reputational damage if they are perceived as failing to respond to climate change.

Credit risks will also be triggered by bank-focused climate regulation, as policy-makers try to implement new environmental policies through changes to banking regulation. Regulators will likely balance climate policy objectives with the need to let banks adapt gradually, avoiding financial market dislocations.

Banks can to some extent anticipate these threats and guard against them through forward-thinking risk management and strategic action. However, lenders that are slow to adapt face negative financial and reputational consequences that will erode their credit strength.