Climate Risks to European Banks: A New Era of Stress Tests

By Alexander Lehmann, a non-resident fellow at Breugel. He focuses on banking and capital markets policy in Europe. Currently, he is also engaged as adjunct professor at the Hertie School of Governance in Berlin, and a consultant to a number of central banks in eastern Europe and the Asian Development Bank. Originally published at Breugel.

Several European central banks have begun assessing the impact of adverse climate scenarios on banks’ capital. Comparable work at EU or euro area level has evolved more slowly. Supervisors need build up a distinct and more complex type of analysis, and should engage with banks now.

The release of a proposed methodology for assessing climate risks within UK banks and insurers by the Bank of England just before Christmas has fuelled calls for a similar ‘climate stress test’ for European banks.

That climate risks should be a significant concern for financial supervisors is no longer in doubt. The central bank Network for Greening the Financial system (‘NGFS’, consisting of now 54 institutions) last year already called for climate-related risks to be integrated into standard financial stability monitoring and supervision. The French and Dutch central banks have conducted quantitative top-down studies and found a substantial potential risk. In the case of the Dutch study, a disruptive climate scenario was shown to reduce insurance sector portfolio values by up to 11 per cent, and banks’ core equity ratio by about 4 percentage points.

Well-defined Shocks in the EU Stress Tests

Stress tests have become the main tool to assess the impact of external shocks on the EU banking system. They are still a relatively new instrument, first used across the EU in 2011, and most publicly in the comprehensive assessment ahead of the ECB taking on its new responsibilities in 2014.

Unlike the US, the EU adopted a bottom-up approach. From the start, banks were given much greater discretion in using their internal models in simulating the impact of the adverse scenario defined by supervisors. This was subject to some limited constraints, for instance in precluding unrealistic asset disposals.

In essence, a single EU exercise has been trying to meet two conflicting objectives: of banks which need to communicate resilience under their own business models to investors; and of supervisors which require a single consistent methodology to gauge the need for additional capital requirements under the so-called pillar 2 approach. This resulted in an increasingly costly and complex iteration between the EBA and the ECB on the one hand, and the banks and their advisors on the other.

Following the ongoing round, stress tests are now due for a significant revamp. In late January, the EBA proposed that future stress tests be split into a top-down exercise led by the supervisor, and a parallel bank-led process that relies on bank-specific internal models to a greater extent (see EBA website).

Climate Risks are Different

Stress tests simulate a single adverse macroeconomic shock that is defined by the EBA, ESRB and national authorities. Country-specific assumptions for key macro variables given banks a clear pathway over a three year horizon. As was again made clear by a comprehensive new report from the BIS and Banque de France, climate change defies such timelines.

Even though the timing is unclear, a combination of transition risks (from a re-pricing of carbon-based technologies), and physical risks (from increasingly frequent severe weather and climate patterns) is now certain to materialize. There are also more drastic scenarios of predominant physical risks (‘no policy action’) or transition risks (‘too late, too sudden’). Either way, there are likely to be sudden impacts (‘tipping points’) and complex spill-overs between corporate, household and sovereign balance sheets. Outcomes are highly dependent on policy action in key polluting countries in the near term, though also on private sectors mitigation, and technological innovation.

The Agenda for EU Supervisors, Banks and Investors

The recent EBA work programme on sustainable finance committed the agency to develop a dedicated climate-related stress tests. This year a voluntary sensitivity analysis is planned, though by 2021 standards for disclosure are to be put in place. Plans for incorporating environmental, social, and governance (ESG) risks into supervision are more tentative, and maty not be taken up until 2024.

Climate risks will add an additional layer to risk management

The first priority for EU supervisors should be to develop plausible common scenarios and share these with banks. Scenario analysis is common in large multinational firms, but what is often a 30-year time-horizon is certain to exceed the planning range of most financial firms. The Bank of England’s proposed assessment, for instance, anticipates three scenarios: timely policy measures that will limit global temperature rise to below 20C; delayed action only in ten years’ time which ultimately succeeds in a similar limitation, though at that point proves highly destabilizing; and no significant policy action which results in substantial temperature increases, and sharp increase in physical risks (damaging weather events, such as storms or floods). Climate scenarios have already been simulated in the insurance sectors of several EU countries and the UK. But they would challenge banks in many ways.

Second, a realistic ambition needs to set in light of the uncertain and drawn-out nature of climate risks. A climate stress would not have the same degree of granularity as is the case currently. As in the BoE proposal initially, the focus should be only on credit losses, not on a comprehensive assessment of the health of a financial firm, its income and capital. Early on, such analysis (an ‘exploratory scenario’ in the terminology of the Bank of England) should not be the basis for capital requirements at bank level. A so-called temperature alignment score could be a helpful and public measure of convergence by individual firms towards the commitment made by states under the Paris Climate Agreement: how much would the world warm based on that firm’s exposures?

Within EU banks climate risks will add an additional layer to risk management. The already complex workaround supervisory stress tests, of course, will need to continue and is essential for bank soundness. But the conventional credit risk analysis based on bank-internal models is not suited to climate risks. Historical correlations embedded in bank models simply cannot capture large and complex risks which have not materialized to date.

Banks should not expect that supervisors will accept assumptions of a rapid divestment from carbon-intensive sectors or an adapted business model. The Bank of England proposes to assess the impact on individual exposures in a constant (static) portfolio of assets in a first-round, and allowing a change in the firms’ business model only in a subsequent exercise. This approach would be in line with the supervisor-driven approach that limits bank-specific flexibility.

Investors, for their part, should not see future EU climate stress tests as offering the same degree of apparent precision that they have come to expect of stress tests. But disclosure and market discipline will be key incentives for changing portfolios and business models. ESG disclosure under the new EU guidelines on non-financial reporting will need to be quickly rolled out by governments (this has already happened with French state-owned companies, and ESG disclosure will be mandatory in the UK from 2022). Our understanding of climate risks in banks will depend on knowing those across the entire real sector.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.

7 comments

  1. bmeisen

    The Frankfurter Allgemeine offered the following on Saturday: an increase of 2 degrees C til 2030 will reduce the return on assets per year in the coal industry by -7% and in oil and gas by -4.5%.

    Reply
  2. Brian James

    This is my personal and favorite speech on and about banking of all time.

    May 21, 2013 Why the whole banking system is a scam

    Godfrey Bloom MEP • European Parliament, Strasbourg, 21 May 2013 • Speaker: Godfrey Bloom MEP, UKIP (Yorkshire & Lincolnshire)

    https://youtu.be/hYzX3YZoMrs

    Reply
    1. notabanktoadie

      Great speech! But I hope Mr. Bloom isn’t or won’t be fooled by the detestable Austrian School of Economics. I suspect not though, he seems way too decent.

      Thanks for this since it spares me the need to comment on the elephant in the room. Also, I feel less alone.

      It was also interesting to see the reactions of other members…

      Reply
  3. Sound of the Suburbs

    How about stress testing economies instead

    How many of the banker’s debt products can an economy take?
    Let’s fill ‘em up and find out.

    At 25.30 mins you can see the super imposed private debt-to-GDP ratios.
    https://www.youtube.com/watch?v=vAStZJCKmbU&list=PLmtuEaMvhDZZQLxg24CAiFgZYldtoCR-R&index=6
    1929 – the US has reached the limit
    1991 – Japan has reached the limit
    2008 – the US, UK and Euro-zone have reached the limit
    After 2008 it was China’s turn, and they did very well, but somehow their experts realised there was a limit, and the PBoC warned about the coming Minsky Moment before it happened.

    How did they do that?
    Davos 2018 – The Chinese know financial crises come from the private debt-to-GDP ratio and inflated asset prices
    https://www.youtube.com/watch?v=1WOs6S0VrlA
    The black swan flies in under our policymakers’ radar.
    They are looking at public debt and consumer price inflation, while the problems are developing in private debt and asset price inflation.

    Does anyone know how to grow an economy without adding more and more debt?
    If not, we are in serious trouble.

    Neoclassical economics has always had an Achilles’ heel.
    The 1920s roared with debt based consumption and speculation until it all tipped over into the debt deflation of the Great Depression. No one realised the problems that were building up in the economy as they used an economics that doesn’t look at private debt, neoclassical economics.
    Not considering debt is the Achilles’ heel of the economics of globalisation.

    What could possibly go wrong?
    It’s not hard.

    Reply
    1. notabanktoadie

      Does anyone know how to grow an economy without adding more and more debt? SoS

      Sure, via an equal citizen’s dividend and other reforms including negative yields and interest on the inherently risk-free debt of monetary sovereigns with an individual citizen exemption up to a reasonable account limit.

      Reply

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