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    FSI Paper Examines Practices for Climate Risk Stress Testing of Banks

    July 14, 2021

    The Financial Stability Institute (FSI) of Bank for International Settlements (BIS) published a paper that examines the key design features of a climate risk stress test for banks and discusses the challenges that emerge when trying to adapt traditional stress tests to banks' climate-related risks. The paper reviews how the identified challenges have been addressed in practice and concludes with reflections about the possible implications for prudential requirements of addressing climate risk. The identified challenges relate to data availability and reliability, adoption of very long time horizons, uncertainty around future pathways of key reference variables covering physical risks, and uncertainty related to transition risks. The paper concludes that methodological changes are needed to make stress tests better suited for climate risks; it also notes that modeling approaches need to be revised to include a climate risk component and to allow for finer sectoral and geographical breakdowns.

    The paper shows how the technical challenges of a climate risk stress test have been addressed in pilot exercises conducted by the Dutch and French authorities in 2018 and 2021, respectively, and in the exercise underway in the UK. These pilots are seen as highly relevant by the authorities and the industry. They are being viewed as a starting point for managing climate-related risks and are expected to be useful in the beginning to identify and assess an increasingly important source of risk. They can also act as a catalyst to further develop modeling techniques that would be better suited to capturing climate risk and to the collection of relevant data. At a minimum, climate stress test exercises, and the ways in which a bank acts on their outcomes, can inform discussions with its supervisor regarding its business model, internal governance, and risk management. However, at this stage the stress tests are considered to be exploratory and preliminary and it is clearly acknowledged that much remains to be improved. 

    An open issue for all authorities is the nature of their follow-up with the industry, although for now climate stress tests are not expected to trigger new capital requirements. Bank stress tests have traditionally been associated with setting a minimum level of capital for each bank and requirements for remedial action when the hurdle rate is not met. For climate risk-related exercises such a requirement is considered premature given the preliminary nature of the exercises and the high-level of uncertainty attached to their results. For this reason, some authorities prefer to describe their current exercises as “scenario analysis” rather than “stress tests.” Irrespective of the labeling, the predominant view in the official community is that no new capital requirements will be introduced on the basis of the outcomes of these stress tests. The outcome of climate change stress tests may inform other supervisory actions. Public communication by authorities engaging in such exercises indicates that they plan to use the exercises in supervisory reviews and supervisory expectations have been set accordingly. Thus, the climate stress test exercises, and the ways in which they inform banks’ decisions regarding their business models and their day-to-day risk management, can become the basis of supervisory discussions; they can facilitate a smooth transition for the banks to a lower carbon economy. Ultimately, such stress tests also contribute to the safety and soundness of the financial system.

     

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    Keywords: International, Banking, Climate Change Risk, Stress Testing, Transition Risk, Physical Risk, ESG, Scenario Analysis, Regulatory Capital, BIS

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