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

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Original languageEnglish
Article number11808
Journal / PublicationSustainability
Volume15
Issue number15
Online published1 Aug 2023
Publication statusPublished - Aug 2023

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Abstract

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. © 2023 by the authors. Licensee MDPI, Basel, Switzerland.

Research Area(s)

  • physical climate risk, residential mortgage loans, probability of default, loss given default, climate stress tests

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