A Common Path to Improve European Climate Risk Stress Testing and Scenarios Analysis

Banks are broadening their scenario analyses using climate risk stress tests to gain valuable insights. However, this report shows a wide range of variables are lacking which results in difficulties in translating “narratives into shocks that generate a statistically significant signal”.

The report, produced by the Association for Financial Markets in Europe (AFME) and consultancy firm Oliver Wyman, examines the effectiveness of the European Central Bank’s (ECB) climate risk stress test (CSRT) and identifies areas for potential improvement.

The authors analyse the findings from a survey of 15 of AFME’s member banks, outlining the CSRT measures they are pursuing in their own operations and where they are going beyond the CSRT. The survey shows progress being made, but recognises a need for increased collaboration. The report specifically calls on financial institutions to work more closely with regulators and global organisations such as the Network for Greening the Financial System (NGFS). The results highlight key challenges that EU banks currently experience in terms of scope, data, time horizons, scenarios and different risk types.

Of the banks that took part in the survey, 85% have taken the initiative to conduct annual internal CSRTs. According to the report, this demonstrates that the vast majority of banks are going beyond regulatory requirements in this area.

Furthermore, the survey indicates that banks are broadening the scope of their scenario analysis beyond credit and market risks to include operational risk, interest rate risk and business liquidity. The results indicate “ the need for refining scenarios and improving data availability and parameterisation”.

The survey reveals that banks are calling for a diversified approach to climate scenario analysis based on materiality analysis, where richer client-level analysis is needed for higher-risk sectors. In contrast, simpler top-down approaches are suitable for lower-risk sectors. Most banks agree there is a need for a broader range of time horizons to accommodate strategic response modelling.

Banks suggest that regulatory climate exercises should focus on high-level dynamic balance sheet modelling over a long-term horizon of 30 years to project transition impacts and fulfil net-zero commitments.

Other research published recently has shown that economic modelling is failing to reflect the true risk that climate change poses to the financial system. The AFME survey also finds that banks are concerned that “most [climate] scenarios fail to fully satisfy the needs with respect to the variability of narratives, range of time horizons, and adequate severity”. Lacking this diverse range of variables makes it challenging to transform narratives into shocks that produce a statistically meaningful signal.

Overall, the report highlights some progress made by the 15 surveyed banks in addressing climate change but emphasises the importance of collaboration, expanded scope, and comprehensive modelling approaches to effectively manage climate risks in the financial sector. The authors find that banks need better understanding of transmission channels for physical risks and improved data governance to support long-term projections of physical risks in future exercises.

The survey also found that some financial institutions do not believe NGFS scenarios are calibrated to provide “extreme but plausible” shocks, which are needed for stress test purposes. Until this is available, banks are relying either on regulatory short-term scenarios provided by the ECB or the more advanced banks are developing institution-specific scenarios.

The authors highlight several recommendations, including:

• future regulatory CSRT exercises should run at a minimum every two years and leverage the experience gained by the ECB’s 2022 exercise;
• banks support the EU’s Fit for 55 exercise in 2024 but early clarity on the process and data requirements are welcomed;
• future regulatory stress tests should consider interaction with other supervisory initiatives and banks internal obligations;
• future CSRT exercises should continue to concentrate on three main risk types: credit, market, and operational.