Prof. Tariqullah Khan

Honorary Research Fellow, Center for Islamic Economics

International Islamic University, Malaysia

The Islamic Financial Services Board (IFSB) is the apex organization of Islamic financial services (IFS) that studies the risks faced by the IFS and adapts the global standards to the special nature of the IFS. Hence, it will make the IFS globally credible. The IFSB since 2009 issues the Global Islamic Finance Stability Report which I have recommended to my students in all my courses. The 2024 report has been released that I have shared with the recommendation that this is the only credible report that represents the IFS industry and its current state and future paths.

Most readers know that I have the preference to talk about the future. As early as 2001, I and Prof. Habib authored the first formal research about Risk Management in the IFS. Since then, I follow the subject.

Climate related financial risks are most important emerging risks. For the first time, the IFSB report has written a formal section addressing the subject and it is an appreciable step. However, the write-up is partial and incomplete.

The IFSB write-up picks up banks‘ responsibility of protecting their assets from immediate risks. This is correct, but one quarter truth. The three quarters of the truth is hidden in banks‘ responsibility towards sustainability of the economic and financial systems in harmony with nature and society.

The distinction between banks‘ roles in responding to climate-related financial risks—the protective role (focused on safeguarding assets) and the proactive role (focused on fostering sustainability)—can be explored more deeply by analysing the underlying dynamics, their respective motivations, and the implications for both the financial system and the broader economy.

1. The Protective Role: Safeguarding Assets and Managing Financial Risks

This role is primarily reactive, grounded in risk management practices that focus on minimizing exposure to financial losses caused by climate change. It is driven by the need to comply with regulatory frameworks and to maintain the stability and resilience of the financial system. Here, climate-related risks are categorized into two main types:

a) Physical Risks

These are risks that arise from the direct impacts of climate change, such as extreme weather events (e.g., hurricanes, floods, droughts etc.) and long-term shifts in climate patterns. Physical risks can damage physical assets, disrupt supply chains, and reduce the value of properties and commodities, all of which can impact the value of a bank‘s loan portfolio and investment holdings. Banks must assess how vulnerable their assets are to these risks and adjust their lending practices accordingly.

b) Transition Risks

These arise from the economic, policy, and technological shifts required to transition to a low-carbon economy. For instance, businesses reliant on fossil fuels may face asset devaluation or become nonviable due to changing regulations (such as carbon pricing) or competition from green technologies. Banks need to ensure that they are not heavily exposed to industries or companies that are likely to lose value as the global economy shifts away from carbon-intensive activities.

Key Actions under the Protective Role

Climate Risk Assessment and Stress Testing: Banks are increasingly required by regulators to conduct stress tests that evaluate the impact of climate change on their balance sheets. This involves assessing both physical and transition risks over various time horizons and adjusting their risk models to account for these factors.

Portfolio Diversification: To minimize exposure to vulnerable sectors, banks may seek to diversify their portfolios, moving away from industries that are susceptible to climate risks and into sectors that are more resilient or have lower exposure to environmental factors.

Enhanced Disclosures: Regulatory bodies, through frameworks like the TCFD, are pushing banks to disclose their exposure to climate risks and the strategies they are using to manage them. This transparency allows stakeholders to assess the financial institution‘s climate resilience and promotes accountability.

Capital Adequacy Requirements: Regulators may impose additional capital requirements for banks exposed to high levels of climate risk, ensuring that they have sufficient reserves to withstand potential losses. This serves to safeguard the broader financial system from systemic risks related to climate change.

This protective approach is motivated by the immediate need to preserve the financial stability of banks and their clients. However, it is reactive and does not necessarily contribute to a long-term transition toward sustainability. While it helps banks mitigate short-term risks, it may not address the broader environmental impacts of their lending and investment practices.

2. The Proactive Role: Driving Sustainability and Responsible Finance

This role is transformative and forward-looking, with banks positioning themselves as agents of change in the sustainability transition. Instead of merely managing the risks that climate change poses to their balance sheets, banks can actively shape the economy by influencing the sustainability practices of the businesses they finance and driving the shift to a low-carbon future.

a) Integrating Sustainability into Core Strategy

In this role, banks go beyond compliance with regulations and incorporate sustainability as a core element of their mission. This involves aligning their business models with the goals of the Paris Agreement and the UN Sustainable Development Goals (SDGs), including decarbonisation and the promotion of circular economies. Banks that adopt this approach view climate change not only as a risk but also as an opportunity to innovate and lead in the transition to a sustainable economy.

b) Influencing Client Behaviour

Banks hold substantial power through their lending and investment decisions. By integrating environmental, social, and governance (ESG) criteria into their credit assessment processes, they can incentivize businesses to adopt more sustainable practices. For example:

Green Loans and Bonds: Banks can provide favourable financing terms to companies that engage in sustainable practices, such as reducing carbon emissions or increasing energy efficiency.

Sustainability-linked Financing: These instruments tie the terms of a loan to the borrower‘s sustainability performance. If a company meets predetermined ESG targets, it benefits from lower financing rates or other favourable terms.

Engagement with High-Impact Sectors: Banks can work directly with carbon-intensive industries to facilitate their transition. Instead of divesting from these sectors outright, they can engage with them to fund innovation in cleaner technologies and transition pathways.

c) Driving Innovation in Green Finance

Banks have a central role in scaling up green finance, which is crucial for funding the transition to a low-carbon economy. This includes:

Financing Renewable Energy Projects: Banks can prioritize financing for renewable energy sectors like wind, solar, and energy storage, as well as related infrastructure projects that support the decarbonisation of the energy grid.

Sustainable Infrastructure Investments: Banks can direct capital to sustainable infrastructure projects that support climate adaptation and resilience, such as climate-resilient housing, transportation, and water management systems.

Circular Economy Financing: Supporting business models that focus on reducing

waste and reusing resources aligns with sustainability goals. Banks can foster innovation in circular economy practices through specialized financing.

Key Actions under the Proactive Role

Aligning with Global Sustainability Goals: Banks that adopt a proactive role align their strategies with international frameworks such as the Paris Agreement, the SDGs, and the Principles for Responsible Banking.

Developing Climate-Positive Financial Products: Green bonds, climate funds, and sustainability-linked loans are examples of how banks can develop products that support environmental goals and mobilize private capital for climate action.

Stakeholder Engagement: Proactive banks engage with a range of stakeholders, including regulators, NGOs, clients, and communities, to create a collaborative approach toward sustainability.

Internal Sustainability Targets: Banks can set internal sustainability targets, such as reducing their own carbon footprints or committing to net-zero emissions across their financing portfolios.

The Need for Proper Emphasis on the Proactive Role

While regulators have focused more on banks‘ protective role, a shift toward emphasizing their proactive role is necessary to achieve the broader sustainability transition. This proactive engagement is essential for addressing the root causes of climate risks and for creating long-term value for both the bank and society.

Several factors make the proactive role increasingly relevant:

Reputation and Long-Term Competitiveness: Banks that integrate sustainability into their strategies may benefit from improved reputations, stronger customer loyalty, and access to new markets. As consumers and investors increasingly prioritize sustainability, banks that lead in this area can gain a competitive advantage.

Regulatory Trends: While regulatory frameworks have traditionally emphasized risk management, there is a growing recognition that financial institutions must play a broader role in promoting sustainability. This is reflected in the evolving focus of financial regulators on ESG integration, sustainable finance taxonomies, and climate transition plans.

Market Opportunities: The transition to a low-carbon economy presents enormous financial opportunities. Banks that proactively support this transition can tap into new markets and create long-term revenue streams from green finance products and services.

Conclusion: Complementing Both Roles for a Balanced Approach

To fully address climate-related financial risks and promote sustainability, banks must balance their protective and proactive roles. While protecting assets from climate risks remains critical, it should not overshadow the need for a broader responsibility. Banks are uniquely positioned to be powerful agents of change, and by integrating sustainability into their operations and business strategies, they can contribute significantly to the global effort to combat climate change and foster sustainable development.

This distinction between the reactive, risk-focused role and the transformative, sustainability-focused role is crucial in reshaping the financial sector‘s response to climate change and in ensuring that the global economy transitions toward a more sustainable and resilient future.