Why climate stress tests must support investment and the role regulators can play

The design of, and response to, climate stress tests around the world is evolving. However, the question now is how should banks and regulators respond to this new information?

There are lingering concerns that many financial institutions around the world treat climate stress tests primarily as a compliance exercise, a box to be ticked, rather than capitalising on the strategic insights on offer.

Potentially of greater concern is that as banks respond to stress test findings, they do so within a narrow set of risk parameters, potentially leading to negative unintended consequences.

As part of our physical climate risk analysis at XDI, we’re starting to see an increasing number of banks introduce screening for risk in new mortgages. Others are beginning to rule out lending to high-risk areas.

These responses – offloading risk and preventing new risk accumulation – are understandable. Financial institutions have a responsibility to protect their shareholders and investors, and reducing exposure to climate risks is part of that duty. However, unless handled thoughtfully this approach could lead to negative outcomes for other lenders and communities.

In the world of climate risk management, good data is essential. Moreover, equal access to good data is vital.

Without access to comprehensive climate risk data, small- and medium-sized lenders are particularly vulnerable to “flying blind” – that is, taking on disproportionate levels of climate risk as their bigger and better-resourced peers offload theirs. This is often compounded by the regional nature of their operations and lending patterns: they may be inherently more exposed to higher risk areas and lack the protection of geographical diversification enjoyed by their larger peers.

A bulletin issued earlier this year by the Reserve Bank of Australia identified small regional banks and credit unions as already carrying higher levels of physical climate risk. This shifting of “climate subprime” to smaller operators is concerning for financial stability.

Fortunately, there is a growing recognition among some regulators that small- and medium-sized financial institutions need better access to physical climate risk analysis and recent technological advancements are making this easier to deliver. For example, XDI has partnered with the Hong Kong Monetary Authority to develop a platform that provides free access to physical climate risk analysis to all authorised institutions under the authority’s jurisdiction.

Avoiding negative social impacts of risk offloading

However, as more institutions gain access to better data and analysis, there is still a broader issue at hand. What happens when all banks begin to offload their climate risks? Will vulnerable communities be left without access to finance and insurance as capital is withdrawn from regions deemed too risky?

This is where regulators have an essential role to play. It is not enough for banks to reduce their individual exposure to climate risks. Regulators must ensure that these efforts do not inadvertently leave communities financially stranded. Simply offloading assets from high-risk areas without considering broader social implications risks destabilising entire regions. The disorderly withdrawal of capital from vulnerable areas could exacerbate inequality, deprive businesses of funding and even increase the likelihood of defaults in affected communities.

Governments must work with stakeholders from the financial services sector and affected communities to establish and support frameworks to ensure that physical climate risk analysis leads to investment in adaptation and mitigation, not divestment and abandonment. In order to do this, several key actions should be considered

First, it is essential that, after undertaking climate stress tests, all financial institutions are required to consider community impacts when responding to identified risks. Climate risk stress testing should be conducted alongside broader government planning and infrastructure priorities to support climate-affected regions.

Addressing climate risk information asymmetries is also a priority to prevent important information being held by a limited number of well-resourced actors. This includes increasing consumer awareness and product disclosure.

Finally, to protect the viability of high-risk communities, adaptation will be key. The financial system needs to be encouraged to develop insurance and lending products that support this.

Most importantly, the unintended consequence of climate risk stress testing must not be disorderly capital flight from affected regions. All involved stakeholders (insurers, banks, regulators, government and communities) need to act together to prevent this from happening in vulnerable areas and promote solutions that protect both financial stability and community resilience.

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