As global temperatures rise and weather patterns grow more erratic, the financial sector stands at a crossroads. Financial institutions and regulators alike grapple with the complex intersection of climate change and monetary stability. No longer a distant concern, climate risk has firmly taken its place among the foremost challenges facing banking supervisors, central banks, and standard-setting bodies.
Across markets, authorities now view climate-related financial risk management as essential to preserving the safety and soundness of the banking system. By demanding robust assessments, clear disclosures, and proactive mitigation strategies, regulators aim to shield investors, depositors, and the broader economy from the fallout of unchecked environmental change.
Why Climate Risk is a Regulatory Issue
Climate change translates directly into financial stability and systemic risk that can no longer be sidelined.
Physical risks manifest in more frequent storms, floods, wildfires, and heatwaves. These extreme events damage infrastructure, disrupt supply chains, and diminish collateral values. At the same time, policy shifts and technology advancements create transition risks. Carbon pricing, emissions regulations, and consumer preferences evolving toward clean energy can erode the profitability and creditworthiness of carbon-intensive sectors.
Beyond these tangible threats, banks and asset managers face liability and reputational risks. Lawsuits, regulatory fines, or allegations of greenwashing can quickly erode trust and trigger funding pressures. Regulators, keen to prevent such outcomes, emphasize the need to quantify exposures and demonstrate resilience.
Regulators rely on established transmission channels to assess how climate risk percolates through the financial system:
- Credit risk: defaults and reduced recovery values for loans and bonds, especially in vulnerable sectors.
- Market risk: sudden repricing of securities tied to fossil fuel assets, also known as stranded assets.
- Operational risk: business interruptions from disaster-related outages and data centre failures.
- Liquidity risk: rapid funding outflows or illiquidity during climate-related shocks.
- Insurance and underwriting risk: rising claims and challenges in pricing premiums adequately.
By understanding these channels, supervisors aim to protect the safety and soundness of individual institutions and to avert systemic crises driven by climate.
Quantifying Climate Risk: Tools and Methodologies
Measuring climate exposures requires a blend of quantitative models, scenario analysis, and expert judgment. The Basel Committee on Banking Supervision (BCBS) and the Network for Greening the Financial System (NGFS) have pioneered methodologies that guide banks through the complexity.
The NGFS publishes long-term macro-financial scenarios that blend climate variables—such as emissions trajectories, temperature pathways, and energy demand—with economic factors like GDP, inflation, and interest rates. These scenarios encompass:
- An orderly gradual transition scenario with gradual policy implementation and predictable shifts.
- A disorderly sudden transition scenario marked by abrupt regulatory changes and fragmented actions.
- A hot house world scenario featuring minimal policy responses and elevated physical risks.
Financial institutions overlay these narratives on their portfolios, conducting comprehensive scenario analysis and stress testing to reveal vulnerabilities and quantify potential losses. The BCBS further outlines measurement approaches, including exposure mapping, portfolio alignment metrics, climate value-at-risk, and sensitivity analysis. Together, they form the backbone of rigorous risk quantification practices.
Mitigation Strategies and Best Practices
Regulators expect firms to move beyond assessment and embrace active mitigation. Core elements of a robust climate risk management framework include governance oversight, risk identification, and continuous monitoring.
At the board level, authorities insist on:
- Integrating climate risk into enterprise-wide risk policies.
- Appointing dedicated committees or units for climate oversight.
- Reviewing climate strategies at least annually or upon major regulatory updates.
Senior management must translate board directives into action, allocating resources, building expertise, and ensuring clear accountability. Many jurisdictions advocate a three lines of defense approach: first-line business units embed climate considerations in credit origination; second-line risk functions validate assessments; third-line auditors provide assurance on effectiveness.
Disclosure Expectations and Reporting Frameworks
Transparent reporting lies at the heart of climate risk regulation. Investors and stakeholders demand decision-useful information on how firms manage environmental exposures. Global standard setters, including the Financial Stability Board (FSB) and the International Sustainability Standards Board (ISSB), have consolidated guidelines around climate and sustainability disclosures.
These standards emphasize governance structures, risk management integration, scenario analysis, and measurable metrics and targets framework. Assurance standards such as ISSA 5000 and IESBA’s ethics guidelines will further bolster the credibility of reported data from 2026 onward.
Navigating Divergences: Global vs National Approaches
While global bodies urge explicit climate frameworks, national regulators vary in ambition. Some jurisdictions forge ahead with stringent rules; others retreat or adopt a neutral stance.
- In Jordan, 2025 rules mandate banks to establish a dedicated climate risk unit and integrate climate into core risk policies within six months.
- European Union initiatives, such as the Sustainable Finance Disclosure Regulation (SFDR), require detailed environmental disclosures across asset classes.
- In October 2025, US federal agencies withdrew dedicated climate principles, reverting to a broader risk-agnostic approach.
These divergences create a patchwork of expectations. Firms operating internationally must navigate overlapping regulations and adapt their risk frameworks to multiple rulebooks.
Collaborating for a Sustainable Financial Future
The complexity of climate risk demands collaboration between regulators, financial institutions, and civil society. International networks like the NGFS and UNEP Finance Initiative foster shared methodologies and best practices, enabling comparability across borders.
In regular forums, central banks share insights on scenario design and data collection, while banks pool resources to enhance risk modelling capabilities. This collective approach not only lowers individual compliance costs but also raises industry-wide standards. By championing cross-border regulatory harmonization efforts, supervisors help create a level playing field where every institution understands its responsibilities and can innovate with confidence.
Ultimately, tackling climate risk requires a unified voice. Whether through technical working groups, industry roundtables, or public consultations, stakeholders must remain engaged and proactive. When institutions commit to open dialogue and transparent reporting, they reinforce the regulatory imperative and drive progress toward a resilient and sustainable financial landscape.
Building Resilience and Seizing Opportunities
Climate risk regulation is not merely a compliance exercise; it offers a pathway to resilience and sustainable growth. By embedding climate considerations into strategic decisions, financial institutions can:
- Identify new lending opportunities in green technologies and renewable energy.
- Enhance reputation and attract responsible investment.
- Reduce potential losses from physical and transition shocks.
Success requires a mindset shift. Instead of viewing regulation as a burden, firms can embrace order in the face of uncertainty by leveraging data, strengthening governance, and fostering a culture of long-term stewardship.
Ultimately, the regulatory lens on climate risk aims to safeguard not only individual institutions, but the entire financial ecosystem. By quantifying exposures, disclosing transparently, and mitigating proactively, the industry can chart a resilient course toward a more sustainable future. Every stakeholder—from board members to junior analysts— has a role to play in translating policy into practice and in building the financial safeguards that our planet, and future generations, so urgently need.
