In 2022, the European Central Bank (ECB) conducted the first European climate risk stress test (CRST), which revealed a gap in understanding the true magnitude of climate risk within the banking industry. Our joint report with the Association for Financial Markets (AFME) offers insights into the actions of banks in this space since the ECB climate risk stress testing exercise and outlines a common path forward.
Through a survey of 15 of AFME’s member banks and engagement with relevant regulatory and supervisory authorities, such as the ECB, European Banking Authority (EBA) and the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), we have seen how banks have developed sophisticated approaches to improve their understanding and analysis of climate risks internally, taking inspiration from lessons learned and supervisory guidance in place.
How banks are going beyond regulation
Banks are going above and beyond regulatory requirements, harnessing climate risk stress tests to gain valuable insights. They're expanding their analysis to include market, operational, liquidity, counterparty, and interest rate risks. Each sector requires a tailored approach, with detailed client-level analysis for higher-risk industries and simpler methods for lower-risk sectors. Banks are also integrating nature risk into their stress test scenarios. However, a consensus is forming that deeper understanding and alignment are needed before incorporating climate risks into financial metrics. Though we have seen substantial progress by banks and significant strides in developing robust climate stress testing capabilities, our findings highlight five key challenges that European banks are currently experiencing when it comes to climate-risk stress testing.
Five key challenges being experienced by European banks
- Low data quality and lack of data are considered the biggest challenges to physical and transition risk modelling. Data is considered the most important tool to accurately assess climate risks across financial risk types. For this reason, in the absence of reliable, consistent, and accessible data, banks’ ability to make realistic projection of climate risks and to provide effective responses is limited. To fill these data gaps, banks rely largely on external vendors.
- The absence of materiality thresholds also remains a key concern because not all financial risk types covered in climate stress test exercises present clear material links to climate risks — which is in turn due to underdeveloped scenarios and data frameworks. As a result, this leads to additional efforts to identify those that have material links to climate risk.
- Although most banks have strong interest in assessing climate-related impacts on portfolios under credit and market risk, challenges remain in terms of how to integrate climate risks into existing risk parameters across all risk types. Up to 20% of banks surveyed shared some level of interest in exploring the impact of climate risks on other financial risk types such as reputational and funding risks, but these are not being strongly considered in European supervisory climate stress tests at this stage.
- Banks would also welcome more focus on shorter time horizons (for example, three to five years) in future stress tests — particularly under transition risk assessment. This would support them in making more realistic projections of climate shocks in line with capital planning and risk management.
- The scenarios currently available have proven to be limited in scope and granularity, creating challenges for banks.
The central role of scenario design
With a deeper understanding of climate risk stress testing, it has become clear that effective scenario design is crucial. The survey revealed that 67% of the banks see the lack of short-term scenarios (for example projections of potential climate impacts over three to five years), alongside insufficient regional granularity of key scenario variables and range of scenario variables as the most material challenge and limitation to using the NGFS scenarios in stress testing. Banks rely on these scenarios to assess risks related to climate transition and physical impacts, but they currently don't have enough parameters, such as short- and medium-term scenarios and detailed narratives for physical risks, to conduct meaningful and measurable scenario analysis. Long-term scenario exercises focusing on dynamic balance sheets are welcomed by banks, as they align with industry strategies to achieve net-zero targets. However, the industry also requires shorter-term scenarios to support planning and risk management but longer-term scenarios are vital for climate risk stress testing. Both industry and regulators need to work together to establish a global view on scenarios
How climate stress testing can help banks tackle climate change
The evolution of climate risk stress testing reflects the banking industry commitment to address climate change and enhances banks' preparedness to navigate the uncertainties it presents, contributing to broader efforts in mitigating the impacts of climate change.
Don't miss out on the valuable insights and recommendations outlined in the full report. Download it now to gain a deeper understanding of climate risk stress testing and how it can help shape a more resilient future for the banking industry.