ECB rebukes banks as climate stress test reveals widespread failures

The European Central Bank (ECB) has told banks to urgently step up their efforts to manage climate risk, after its inaugural stress test found they are failing to sufficiently incorporate the issue into their risk management frameworks and internal models. Civil society groups have also expressed concern over the extent of banks’ credit risk in the mortgage sector.

The ECB assessed the effect of a combination of higher carbon prices and extreme weather events on a sample of 41 institutions, finding that such a scenario would result in losses of over €70bn. In a report published on Friday, it said this figure is likely to be a significant underestimate, due to a scarcity of data and the fact the scenario does not take into account indirect effects such as an economic downturn.

“Euro area banks must urgently step up efforts to measure and manage climate risk, closing the current data gaps and adopting good practices that are already present in the sector,” said Andrea Enria, chair of the ECB’s supervisory board.

The central bank has said it has no immediate plans to adjust institutions’ capital requirements based on the exercise, but hopes it will provide lessons for both banks and supervisors and will feed into the ECB’s wider climate roadmap. All participating institutions have received individual feedback and are expected to take action accordingly, in line with the best practices that the ECB will publish in the final quarter of 2022.

“This exercise is a crucial milestone on our path to make our financial system more resilient to climate risk,” said Frank Elderson, vice chair of the ECB’s supervisory board. “We expect banks to take decisive action and develop robust climate stress-testing frameworks in the short to medium term.”

The stress test also revealed the extent of eurozone banks’ reliance on high-carbon lending, with participants generating almost two-thirds of their income from greenhouse gas-intensive industries. The ECB said banks’ exposures are mostly concentrated in a small number of companies.

Civil society groups have highlighted the extent of banks’ credit risk in the mortgage sector, arguing it strengthens the case for EU institutions and financial regulators to support green housing renovation initiatives.

Stanislas Jourdan, executive director of the Positive Money Europe campaign group, said the ECB has acknowledged that credit risk is correlated with the energy efficiency of real estate, but noted the stress test’s finding that banks are neglecting to collect relevant data about the properties they lend against.

The ECB acknowledged the possibility that the climate risk scenarios considered in the stress test exercise might be out of date following the energy price shocks resulting from recent geopolitical developments including Russia’s invasion of Ukraine. Jourdan suggested the exercise may have underestimated the impact of rising prices on mortgage holders and banks.

“Far more people across Europe are going to struggle to repay their mortgages in the coming years than the ECB’s results today suggest,” he warned. “Mortgage holders face a triple whammy of rising living costs, soaring energy bills and higher mortgage repayments. The ECB must urgently unlock funding for people to insulate their homes.”

Positive Money Europe is among a coalition of organisations calling on the ECB to pilot a green lending scheme to offer banks cheap financing for loans dedicated to building renovations.

The ECB is the latest major central bank to carry out a climate stress test, following similar exercises at the Bank of England and the People’s Bank of China over the past year. Although the Federal Reserve has yet to reveal any firm plans to follow suit, chair Jerome Powell has said stress tests will “likely be a key tool going forward”.