An analysis by the Bank of Korea showed that if climate change is not addressed, the nation's financial sector could face losses exceeding 45 trillion won. There is also a possibility that the capital ratio, an indicator of financial soundness from the Bank for International Settlements (BIS), could fall below the regulatory ratio (11.5%). Accordingly, the Bank of Korea advised that measures should be improved for systematic management of climate risk and that green investments should be promoted.
On the 18th, the Bank of Korea, in collaboration with the Financial Supervisory Service, held a "Climate Finance Conference" at the Bank of Korea headquarters in Sogong-dong, Seoul, where they announced the results of the "top-down climate change stress tests for banks and insurance companies." The tests were led by the Bank of Korea's Sustainable Growth Office, and 14 financial institutions participated (7 banks, 4 life insurance companies, 3 non-life insurance companies).
A stress test refers to an assessment of the potential vulnerabilities of the financial system in response to exceptional but plausible events. The Bank of Korea focused on early identification of the impacts of climate risk on financial stability through this test and aimed to strengthen the risk management capabilities of domestic financial institutions.
◇ If there is no climate response, losses in groceries, restaurants, and construction will increase
The Bank of Korea conducted stress tests based on four scenarios: (1) achieving carbon neutrality by reducing the temperature increase to ▲1.5℃ by 2050 (1.5℃ response); (2) controlling it within ▲2℃ and reducing carbon emissions by 80% compared to the current level (2.0℃ response); (3) delaying responses until 2030 and then rapidly implementing carbon neutrality policies to reduce temperatures to 2℃ by 2050 (delayed response); and (4) not implementing climate policies at all (no response).
According to the analysis, the expected loss for the financial sector (based on 7 banks and 7 insurance companies) was estimated to be about 27 trillion won for the 1.5℃ and 2℃ responses. However, in the case of a delayed response, the expected loss increased to approximately 40 trillion won due to risks associated with the rapid reduction in carbon emissions. In a no-response scenario, damages from high temperatures and heavy rainfall increased the loss to 45.7 trillion won.
By type of risk, banks accounted for more than 95% of total expected losses from credit losses (losses due to borrower defaults), while insurance companies had a high proportion of market losses (losses that occur as the value of stocks and bonds changes due to market value fluctuations). For non-life insurance companies, insurance losses (losses incurred due to an increase in insurance payouts) accounted for about 6% of total losses.
Losses also varied by sector. The implementation of climate response policies would result in significant losses in industries such as steel and metal processing, and without response, losses would expand in groceries, restaurants, construction, and real estate. For insurance companies, losses in the electronics manufacturing sector, where the investment share is relatively high, accounted for a significant proportion of losses across most channels.
◇ BIS ratio falls below regulatory level… "Early climate response is essential"
In this test, the Bank of Korea also examined the impacts of climate change risk on key financial soundness indicators such as the Bank for International Settlements (BIS) capital ratio and solvency ratio. The BIS ratio measures the ratio of capital to risk-weighted assets, while the solvency ratio indicates a life insurance company's solvency amount (assets - liabilities + internal reserve assets) divided by a solvency benchmark amount (4% of the reserve for liabilities + 3% of the risk premium). Higher numbers indicate better financial soundness for the institutions.
The analysis showed that the BIS ratios of some banks fell below the regulatory ratio (11.5%) depending on the scenarios. In the case of a 1.5℃ response, the BIS ratio is expected to drop to 8.0% by 2050 but then recover to 11.5% by 2100. The decline was limited in the 2.0℃ response (13.1% by 2050, 12.3% by 2100), while in the delayed response scenario, it fell to 6.5% by 2050 and remained at about 10.6% by 2100. In the case of no response, the BIS ratio dropped to 10.0% due to increased damages from high temperatures and rainfall by 2100.
In contrast, insurance companies' solvency ratios remained above the regulatory ratio (100%) in all scenarios. In the case of a 1.5℃ response, the solvency ratios for life and non-life insurance companies dropped to 197.7% and 186.7%, respectively, by 2050 but gradually recovered, rebounding to 206.4% and 198.7% by 2100. In the event of no response, there was little change until 2050, but as market losses and insurance losses increased, they dropped to 196.8% and 181.4% by 2100.
The Bank of Korea advised that to systematically respond to climate risks, financial institutions should improve the "risk management guidelines" for financial institutions, make "climate scenario analysis and stress testing" mandatory, and strengthen preparations for unexpected losses, while also promoting green and adaptive investments. Green investments refer to those that contribute to environmental improvement, while adaptive investments refer to those aimed at reducing vulnerability to climate crises.
The Bank of Korea noted that if global carbon reduction efforts diminish as a result of the United States' withdrawal from the climate agreement, the potential for more frequent and severe natural disasters could increase, heightening downward pressure on the capital ratios of financial institutions. They said that early implementation of climate response policies is expected to benefit individual institutions' management soundness and financial market stability.
◇ FSS conducts tests on 36 financial institutions… "25 trillion won loss in no response scenario"
On the same day, the Financial Supervisory Service unveiled the results of the climate stress tests conducted on 36 financial institutions with corporate loans exceeding 1 trillion won. The FSS analyzed the scenarios of limiting the rise in global average temperature to within 1.5℃ by 2100 and not reducing emissions in a no-response scenario.
The analysis indicated that if carbon neutrality is achieved, financial sector losses due to natural disasters are estimated at 19.5 trillion won, whereas in a no-response scenario, the loss scale increased to 25.1 trillion won. The total capital ratio of the banking sector is expected to fall by 3.1 percentage points (p) under the carbon neutrality scenario and by 3.8 p under the no-response scenario, while the K-ICS ratio for the insurance sector is projected to decrease by 1.8 p with carbon neutrality and by 2.9 p in the case of no response.
In particular, the loss rate for financial institutions located in rural areas (2.0%, the loss ratio compared to the outstanding corporate loans) was found to exceed that of major banks (1.3%). This is due to the concentration of high carbon-emitting manufacturing industries (such as steel) and natural disaster-sensitive sectors (such as retail) in rural areas, making them more vulnerable to climate risks.
The FSS argued that while the effects of carbon reduction have been proven, it is necessary to prepare "transition finance guidelines" to activate investments that meet some green criteria, and that financial institutions and local governments with significant exposure to climate risks due to concentration of manufacturing should strengthen support for low-carbon transition financing.