ECB climate stress testing framework shows loss amplification

June 17, 2022|Written by Graham Caswell|European Central Bank

Using an enhanced system-wide stress testing framework, researchers from the European Central Bank (ECB) have found that in a disorderly transition scenario climate-related financial losses are likely to be significantly amplified by the market reactions of banks, investment funds and insurers.

Outlined in the ECB’s latest Macroprudential Bulletin, the framework goes beyond single-sector stress testing models to simultaneously analyse the response of financial companies to both physical and transitional climate shocks. By acknowledging the interactions between financial institutions, the framework produces a more realistic indication of the effects of climate change on the financial system.

There are multiple interconnections between banks, investment funds and insurers involving both loans and cross-holding each other’s securities, resulting in interrelated channels of contagion risk as a result of market, liquidity and solvency dynamics within the financial system. The ECB framework models these dynamics using firm-level data and the disorderly transition scenario created by the Network for Greening the Financial System.

The initial climate-related shocks from the disorderly scenario would result in contagion effects through both credit and market risk channels, the analysis shows. Under fire sale conditions, losses of investment funds would significantly amplify banks’ capital depletion, with contagion from cross-holdings of securities and overlapping portfolios being the main amplification channel.

Non-bank financial institutions would be the main contributors to overall system losses, the model finds, with investment funds contributing 55% and the insurance sector 39%.

“System-wide stress testing models are not only useful for the evaluation of climate risk but can also be used to analyse different macroprudential policies or changes in monetary policy stances,” the analysis concludes. Bank-specific climate capital buffer requirements or fund-level redemption restrictions could be added as additional constraints, it suggests, while including granular Eurosystem asset holdings would make it possible to evaluate second-round amplification effects from changes to ECB asset purchases.

This page was last updated June 17, 2022

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