The Governor of the Central Bank of Cyprus, Christodoulos Patsalides, highlighted the challenges and opportunities facing the banking system in a climate of global uncertainty and emerging risks at the “Credit Risk Management Conference – ESG Impact on Credit Risk.”

Addressing the new environmental, social, and governance (ESG) requirements, the Governor emphasized the importance of banks adapting to these risks, which directly impact credit ratings. Banks must now conduct a more thorough analysis of borrowers' resilience, focusing on how these emerging factors influence their creditworthiness.

Patsalides pointed out that environmental risks, such as the increasing frequency of extreme weather events, accelerated impacts of climate change, and regulatory shifts toward green transitions, could directly affect a borrower’s creditworthiness and resilience. He also underscored the growing significance of social and governance factors in credit risk assessment. Issues like labor practices, social profile, employee well-being, and inclusivity could influence an organization’s reputation, impacting its operational cycle.

The Governor also discussed how geopolitical risks and rising protectionism could disrupt market stability, trade flows, and supply chains, substantially affecting credit risk. These risks extend to cyber threats and infrastructure vulnerabilities, which place the banking system in a new arena where threats could compromise its viability.

He noted that banks are now emphasizing understanding how new risks emerging from the current period of intense uncertainty can reshape fundamental parameters of loan credit risk.

"In this way, banks aim to manage their credit risk exposure more effectively while aligning their portfolios with the need for a transition to a more sustainable and green economy, as well as an environment filled with unpredictable factors and risks," he stated.

This approach, he added, is fully aligned with the pressure exerted by regulators and the expectations of the investment community, as the market increasingly demands transparency and accountability in how financial institutions integrate these risks into their decision-making processes.

The Governor outlined that a primary challenge in incorporating these risks into banks' risk management practices is the lack of qualitative and reliable data. 

"Although financial institutions have become more aware of the need to integrate these risks into their credit evaluations, inconsistent or incomplete publications and data hinder the process," he explained.

He added that smaller and medium-sized enterprises (SMEs), which make up a large portion of Cypriot banks' loan portfolios, lack standardized reporting methods for these factors, making it challenging for banks to accurately assess their risk profile. Even when data is available, particularly for larger borrowers, there is often inherent difficulty in integrating it into traditional credit risk models commonly used by financial institutions.

"The need for forward-looking data is also a critical issue of paramount importance. Traditional risk models rely on historical data to predict future risks; however, emerging risks—especially those related to climate change and geopolitical instability—often require predictive models that go beyond past trends," Patsalides noted.

He emphasized that the impact of these challenges and inherent difficulties could be mitigated through an outward-looking and effective governance framework that promotes open and honest collaboration and exchange of ideas, allowing decisions to be based on collective wisdom and better reflect the factors influencing the bank’s operations.

He also stressed the importance of a distinct division of responsibilities within the governance structure. This approach enables risk identification, detection, and management to be carried out more efficiently and in a timely manner, mitigating the impact of factors and parameters with inherent modeling difficulties and challenges.

Discussing opportunities, Patsalides noted that with a forward-thinking and outward-looking approach, banks could strengthen their risk management frameworks and set an example in sustainable finance, playing a crucial role in the transition to a greener, socially sensitive, digital, and resilient economy.

"Financial institutions that successfully integrate emerging risks into their credit assessment models will be in a favorable position to identify high-quality credit opportunities and support their clients and the economy in achieving ambitious global sustainability goals," he said.

He added that this would positively influence their access to capital markets, resulting in a positive impact on their funding costs.