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    ECB Report Sets Out Good Practices for Climate Stress Testing

    The European Central Bank (ECB) published a report that provides banks with examples and suggestions on improving their climate stress testing capabilities based on identified good practices from the 2022 ECB Climate Stress Test.

    The report presents a set of useful good practices obtained during an in-depth assessment of information provided by banks. The report outlines the criteria used to identify good practices, provides information on the advanced approaches to internal climate risk stress testing frameworks with respect to the scope of the frameworks, the choice of scenarios, and the balance sheet assumptions used. It also describes the advanced approaches used by banks to collect climate-relevant data and the proxy methods developed to estimate such data and covers the following data categories: the allocation of banks’ income to industrial sectors, the geolocation of counterparties and of collateral from real estate portfolios, data on greenhouse gas emissions of counterparties and data on EPCs for real estate. It then illustrates good practices identified with respect to the integration of climate-related risks into credit risk models and covers the transmission channels used in banks’ models to transmit the climate shock to credit risk parameters as well as the approaches identified in climate risk-adjusted probabilities of default (PDs) and losses given default (LGDs). Modeling approaches relative to long-term scenarios are also analyzed in detail, along with the methods used to include risk mitigants.

    In the report, ECB notes that institutions that are more advanced in their data sourcing approaches and estimation methodologies for climate data are also more advanced with respect to quantifying the impact of climate-related risk on their exposures.  In many cases, credit risk parameters projected by banks were found to be insensitive to the climate risk shocks depicted in the scenarios. Observed good practices mainly focus on transition risk and the transmission to probability of default, while only a few institutions have already developed approaches to quantify the impact of transition risk on loss given default. It seems that there has been less progress with respect to the integration of physical risk into credit risk models and hence this is one of the areas identified by ECB in which banks need to step up their efforts. The good practices outlined in this report should help banks and supervisors to prepare for future climate stress test exercises. ECB expects banks to further develop their climate stress test frameworks and their data and analytical capabilities and to progress beyond the examples of good practices provided in this report. This report should be read in conjunction with the report on good practices from the 2022 thematic review (which was published last month).

     

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    Keywords: Europe, EU, Banking, Basel, Stress Testing, Climate Change Risk, Scenario Analysis, Credit Risk, ESG, ECB

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