A Framework for Integrating Extreme Weather Risk, Probability of Default, and Loss Given Default for Residential Mortgage Loans

This paper considers a hypothetical case in which a bank wants to build a routine climate stress test exercise on residential mortgage loans. The bank has regularly updated the probability of default (PD) and loss given default (LGD) on each residential mortgage loan under the internal-rating-based...

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Bibliographic Details
Published in:Sustainability 2023-08, Vol.15 (15), p.11808
Main Authors: Wong, Michael C. S, Ho, Ho Ming
Format: Article
Language:English
Subjects:
Bank loans
Banking industry
Banks
Banks (Finance)
Climate change
Credit risk
Default
Extreme weather
Interest rates
Literature reviews
Loans
Mortgage-backed securities
Mortgages
Property values
Simulation methods
Sustainability
Valuation
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Summary:This paper considers a hypothetical case in which a bank wants to build a routine climate stress test exercise on residential mortgage loans. The bank has regularly updated the probability of default (PD) and loss given default (LGD) on each residential mortgage loan under the internal-rating-based (IRB) approach of Basel II/III. Additionally, the bank estimates the stressed PD and stressed LGD associated with a predetermined extreme weather event. Using simulation techniques, this paper shows that the loss of the bank’s residential mortgage portfolio can reach a median of around 36% of the portfolio value. This remarkable loss comes from the effects of default correlation and property damage. Banks should pay more attention to such impacts of extreme weather events.
ISSN:2071-1050
2071-1050
DOI:10.3390/su151511808