How Climate Change May Impact Operational Risk

Abstract

The Basel Committee on Banking Supervision has noted that there has been 'very limited focus' on the impacts of climate change on operational risk. This paper seeks to address this lack of focus. It concludes that climate change may drive operational risk losses through complex interactions between three factors: changes in human and institutional behaviors, significant and rapid changes in economic metrics and direct physical impacts. The influence of these three factors varies depending on the course of action pursued by humanity: if early action is taken now, then changes in human and institutional behaviors would be most influential, and the economic consequences would be limited to specific vulnerable sectors; if, instead, late action is taken, then in the 2030s a demand-side economic shock would drive operational risk losses; while if no additional action is taken at all, then from the 2040s onwards extreme events causing economic shocks through supply-side disruption would combine with behavioral changes to drive operational risk losses. This paper uses the ten laws of operational risk as well as taxonomies for inadequacies or failures and their impacts, and it also draws parallels with past crises, in order to systematically make predictions. This paper also explains how tailored approaches are required to assess these different consequences. Finally, it observes that the most significant operational risk losses may arise from litigation around the transference to customers and investors of market and credit risks without adequately disclosing the sensitivities of those risks to climate change, in particular to the associated economic shocks. Control enhancements now, however, may mitigate these future losses.