ECB releases bank climate stress test methodology

October 19, 2021|Written by Graham Caswell|Danmarks Nationalbank, European Central Bank, Federal Reserve

The European Central Bank (ECB) has published the methodology for its upcoming climate stress test to undertake an assessment of Eurosystem banks.

The ECB’s Climate Risk Stress Test will require lenders to report on a common set of climate risk metrics, including the volume of greenhouse gas emissions they finance. Banks will also be required to assess their exposure to short term physical and transitional climate risks, and to evaluate their response to common transition scenarios over the next 30 years.

Part of the second stage of the ECB’s climate plan, the exercise will be conducted from March to July 2022 and will consist of three modules: an assessment of banks’ climate stress test capabilities; a peer benchmark analysis of climate risk metrics; and a ‘bottom-up’ stress test focusing on transition and physical climate risks. Banks will be required to assess the financial effects of extreme weather events over the next year and of a sharp increase in the price of carbon over the next three years.

While the climate stress test is comprehensive, the ECB made clear in an accompanying letter that it considers the assessment as a “learning exercise for banks and supervisors alike” and sees no direct capital impact for banks.

An economy-wide climate stress test published by the ECB last month found that flooding, wildfires and other physical climate risks could have a “very significant” impact on European corporations and the banks that fund them, with effects concentrated geographically and by sector.

Studies from the European Systemic Risk Board, Danmarks Nationalbank, and campaigning thinktank Reclaim Finance have also shown concentrated climate-related financial risk among Europe’s largest banks, with resulting risks to eurozone financial stability.

However, Eurosystem banks have been slow to face the impact of the climate crisis on their operations. A 2020 ECB report found that banks were “lagging behind” on climate-related risk reporting, with just 3% of eurozone banks making fully comprehensive disclosures.

A more recent ECB review found that over 65% of eurozone banks do not expect to align their credit and liquidity risk management practices with ECB expectations for 2022. In addition,  a Bloomberg survey of 20 major European banks found near-universal agreement that the banking sector will not meet ECB guidelines in 2022, largely because of poor client data and the need to coordinate with regulations outside the EU.

Despite these challenges, the ECB remains a pioneer in supervising climate risk to the financial industry, contrasting starkly with US financial regulators who have barely begun to assess the vulnerability of US banks to climate change.

A New York Fed staff research report released in September outlined a basic climate stress test process based on existing data and focusing on capital shortfalls of financial institutions in a climate stress scenario. However, this remains the Fed’s only publication examining bank vulnerabilities to climate change.

Speaking at a research conference in Boston last week, governor Lael Brainard suggested the Fed will provide supervisory guidance on climate risks to banks, but did not give details or a timeline.

This page was last updated October 19, 2021

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