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    EU to Conduct One-Off Scenario Analysis to Assess Transition Risk

    The European authorities recently made multiple announcements that impact the banking sector. Among them, the Securities and Markets Stakeholder Group (SMSG) provided advice to the European Securities and Markets Authority (ESMA) on the consultation on guidelines for funds names using ESG or sustainability-related terms. In addition, ESMA published a list of Synthetic Securitizations, a set of Questions and Answers (Q&A) on the European crowdfunding service providers regulation, and the guidelines on standard forms, formats, and templates to apply for permission to operate a Distributed Ledger Technology (DLT) market infrastructure (in effect from March 23, 2023). Finally, the most notable development is the European Commission (EC) request to the European Supervisory Authorities (ESAs), the European Central Bank (ECB), and the European Systemic Risk Board (ESRB) to conduct a one-off scenario analysis exercise to assess transition risks in the move toward a more sustainable economy.

    The EC letter notes the importance of ensuring that financial institutions are well-prepared to handle the transition to a low-carbon economy, as this will require significant investment and changes to the business model. The letter emphasized the need for cooperation and coordination among financial institutions, regulators, and policymakers to ensure a smooth transition to a low-carbon economy. Therefore, EC is inviting ESAs, ECB, and ESRB to cooperate in a one-off exercise, which will assess the resilience of the financial sector and is different from the usual climate stress tests. EC is inviting the development of severe but plausible scenarios that could affect the financial system as a whole over the period up to 2030. One of the scenarios should focus on climate-change related risks that could already materialize in the near term, whereas the other scenario could combine such climate-change related risks with other stress factors. The adverse scenario(s) should be developed by the ESRB’s Task Force on Stress Testing to ensure consistency across sectors and synergies with the scenarios used in another stress test.

    According to EC, the purpose of this exercise is not to set micro- or macro-prudential requirements for financial institutions; thus, the exercise should not limit itself to estimating capital losses and shortfalls in financial institutions. The results in terms of capital losses/adequacy should then feed into a modeling process indicating how shocks and their possible amplification through contagion and second-round effects could affect the overall availability of capital and economic activity. Results should be as differentiated (notably by countries, types of financial institutions, economic sectors) as possible so that they can be used by policymakers to better understand how climate-related shocks can affect the financial system in the period up to 2030.

    EC expects to receive results from this exercise ideally by the end of 2024 and in any case not later than the first quarter of 2025, to provide input to the work of the new European Commission. The exercise should, therefore, be launched as soon as possible and could be based on ethe nd-2022 balance sheet data. The team in charge of conducting the exercise should develop a detailed roadmap and timetable and report on progress, to the governing bodies, of the addressees and the Commission at key moments, and in particular when the scenarios are to be validated, the sectoral work is completed, and fed into the cross-sectoral modeling and at the beginning of the phase in which all elements will be integrated into the final report. As per EC, the final deliverable should be an integrated single report combining the sectoral work conducted in a consistent manner and the cross-sectoral modeling. 

     

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    Keywords: Europe, Banking, ESG, DLT, Q&A, Synthetic Securitization, SMSG, Climate Change Risk, Scenario Analysis, Crowdfunding Service Providers, Transition Risk, Stress Testing, ECB, ESRB, ESMA, EC

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