The European Central Bank (ECB) published results of the climate risk stress test, for 2022, among the significant institutions. The results show that banks do not yet sufficiently incorporate climate risk into their stress-testing frameworks and internal models, despite the progress made since 2020.
The stress test, which is a part of the wider climate roadmap of ECB, was a learning exercise for both banks and supervisors to assess the sector’s preparedness for managing climate risk and identifying best practices for dealing with this risk effectively. About 104 significant banks participated in this test, which had three modules. Through these modules, banks provided information on their climate stress-testing capabilities, reliance on carbon-emitting sectors, and performance in different stress test scenarios over several time horizons:
The results of the first module show that nearly 60% of the banks do not yet have a climate risk stress-testing framework. Most banks do not include climate risk in their credit risk models while only 20% consider climate risk as a variable when granting loans.
The second module of the test found that, on aggregate, almost two-third of banks’ income from non-financial corporate customers stems from greenhouse-gas-intensive industries.
Under the third module, findings of the bottom-up stress test, which was limited to 41 directly supervised banks, show that the vulnerability of banks to a drought and heat scenario is highly dependent on sectoral activities and the geographic location of their exposures. In terms of long-term projections under different climate risk scenarios, the results show that an orderly green transition translates into lower losses than disorderly or no policy action. Banks lack robust strategies, other than the tendency to reduce exposures from the most polluting sectors and to support lower-carbon-emitting businesses.
While acknowledging the many challenges banks are facing with regard to climate risk stress testing, the exercise showed that in each of the assessed areas, at least some of the banks were able to address the challenges in a satisfactory manner, suggesting that it is possible for the industry to raise the bar across all of the areas assessed. ECB also published a presentation on the results of this exercise and set out recommendations to banks. In general, ECB plans to follow up on the findings with bank-specific recommendations and guidance on best practices in climate stress testing. The main focus will be on helping banks to build their internal climate risk stress-testing frameworks and overcome the current challenges. All participating banks are expected to receive individual feedback to take action accordingly, in line with the set of best practices that ECB will publish in the final quarter of 2022.
Climate Stress Test Results (PDF)
Presentation on Climate Stress Test (PDF)
FAQs for Climate Stress Test
Keywords: Europe, EU, Banking, Stress Testing, Climate Change Risk, Climate Stress Test, ESG, Net Zero Transition, Lending, ECB
Hasan leads Moody’s Analytics ESG methodology development. He is expert on carbon transition, nature related risks and is a guest lecturer at ESSEC Business school on sustainable finance.
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