60% of banks don’t have a climate risk stress testing framework; only 20% consider climate risk when granting loans.
The European Central Bank (ECB) has released the results of its first climate risk stress test, saying the findings suggest that banks need to do more to sharpen their focus on climate risk.
The ECB found that most EU banks do not sufficiently incorporate climate risk into their stress-testing frameworks and internal models, and that they must step up efforts to measure and manage climate risk, close data gaps and more broadly adopt good practices in this area.
Banks fall short
A total of 104 banks participated in the test, which consisted of three modules: banks’ climate stress-testing capabilities; their reliance on carbon-emitting sectors; and their performance under different scenarios over several time horizons.
The report says about 60% of banks do not yet have a climate risk stress-testing framework, most banks do not include climate risk in their credit risk models, and just 20 percent of banks consider climate risk as a variable when granting loans.
“Banks currently fall short of best practices, according to which they should establish climate stress-testing capabilities that include several climate risk transmission channels (e.g. market and credit risks) and portfolios (e.g. corporate and mortgage),” the ECB said.
As for their reliance of banks on carbon-emitting sectors, the ECB said almost two-thirds of banks’ income from non-financial corporate customers stems from GHG-intensive industries, with higher-emitting sectors accounting for 21 percent. In many cases, banks’ “financed emissions” come from a small number of large counterparties, which increases their exposure to emission-intensive sectors.
Banks also often rely on proxies to estimate their exposure to emission-intensive sectors. While this is a good first step to closing the data gaps, banks need to step up their customer engagement to obtain more accurate data and insights into their clients’ transition plans, the ECB said.
The third module required 41 banks to project losses in extreme weather events under different transition scenarios. The findings show that banks’ vulnerability to a drought and heat scenario is highly dependent on sectoral activities and the geographical location of their exposures. Similarly, in the flood risk scenario, real estate collateral and underlying mortgages and corporate loans are expected to suffer, particularly in the most affected locations.
The results suggest that credit and market losses could amount to around €71 billion (US$72 billion) on aggregate this year for the 41 banks in the worst scenario, which includes droughts, heat, floods and a sudden jump in carbon prices.
The report says this result “significantly understates” the actual risks related to global warming, because of the scarcity of available data, the exclusion of economic downturns and second-round effects from the scenarios, and the exercise only accounted for around one-third of the total exposures of the 41 banks.
Last year’s traditional banking stress test, which modeled economic shocks and took into account the impact of the Covid-19 pandemic, saw almost €400 billion of credit and market losses across 50 banks.
The ECB will consider changing the rules for future climate stress tests, including to potentially add a severe economic downturn.
Overall, the results show that an orderly green transition would lead to lower loan losses by 2050 compared to the disorderly and hot house world scenarios, particularly for sectors with high carbon intensity, such as mining and minerals.
The report concluded that most banks would need to work further to incorporate climate risk into their credit risk modelling, and improve their stress test frameworks’ governance structure, data availability, modeling techniques.
“This exercise is a crucial milestone on our path to make our financial system more resilient to climate risk,” said Frank Elderson, vice-chair of the ECB supervisory board. “We expect banks to take decisive action and develop robust climate stress-testing frameworks in the short to medium term.”
The ECB plans to feed the results of the stress test into its annual review of risks in the banking sector. There will not be any direct impact on capital through the Pillar 2 guidance this year. All participating banks have received individual feedback and are expected to take action accordingly, in line with the set of best practices that the ECB will publish in Q4 2022.
The ECB is carrying out a separate thematic review to gauge banks’ progress towards incorporating climate and environmental risk into their business. It expects them to meet its expectations by end-2024 at the latest.