GARP SCR: Climate impacted PD curve shifts to right

This is a very interesting question posed by Valentina Ricciuti (group member of the Linkedin group https://www.linkedin.com/groups/12842133/)  related to Probability of default (PD) curve as shown in the below diagram. She asks as to why the PD curve shifts to the right due to climate change impact. 

(Below image is from Chapter#6)

                                                              Figure from Chapter#6

Below is the explanation in 3 simple figures

Figure 1: PD curve without the climate change

The graph in Figure 1 is a histogram of the count of defaulting loans – say a home loan or a home mortgage - date collected by the bank over a period of 2000-2010. On the X-axis or horizontal axis, there are some categories like -25%, -5%, 0 %, 5%, 25% etc..  Consider this curve to without climate change

Example: 5% represents a category where 5% of home loans were defaulted, similarly 10% represents a category where 10% of home loans were defaulted and so on whereas -5% represents totally opposite, which means, 5% of loans were foreclosed before the agreed schedule, -10% represents a category where 10% of home loans were foreclosed and so on. 0% represents the "mean" which can be interpreted as a category where the loans are paid as per the schedule and rate agreed with the bank.

Height of each shaded bar represents the count of home loans for each category. Probability is calculated as the count of loans per category divided by total count of home loans availed.

                                            Figure 2: PD curve with the climate change

Figure 2 represents a histogram of the count of defaulting loans – say a home loan or a home mortgage - date collected by the bank over a period of 2011-2020. Consider this curve considering the impact of climate change.

Due to the worsening climate change, the people suffer losses and are unable to pay loans on time. This can be because of say floods that people suffer losses, businessmen suffer losses as their businesses are impacted.  Their capacity to repay the loan reduces and default increases. More and more defaults happen.You can compare the count of different categories against the corresponding categories in Figure 1

In the below figure (Figure 3), we have superimposed both Figure 1 and Figure 2. We see that there has been a shift in the mean of the curve towards the right

Figure 3: On superimposition of both the curves, it is seen the curve shifts to the right

Hope it is clear. Please share your comments/feedback in the comment section. Happy learning!

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