Climate Stress Tests

In this policy note, Deutsche Bank researcher Ursula Walther reviews the landscape of climate stress testing (CST) by central banks and financial regulators. Produced by the European Money and Finance Forum (SUERF), Walther’s report highlights the growing pressure on banks to improve their climate risk management and disclosure frameworks, and argues that initial stress tests are “just the beginning”.

The report draws on research commissioned by Deutsche Bank which found a convergence of results from stress tests, namely that climate risk can have a sizable and negative impact on bank profitability. Citing testing exercises by the European Central Bank (ECB), Walther says research points to “a greater exposure of larger banks” to transition risk, adding that global systemically important and universal banks are more exposed to high-carbon risk sectors.

Walther notes that CSTs are increasingly common, pointing to a 2022 survey by the Financial Stability Board which found that, worldwide, 67 climate stress tests have been completed, are ongoing or are in planning. While testing is in the early stages and does not yet have direct implications for capital frameworks, the ECB included qualitative findings in its 2022 supervisory review and evaluation process (SREP), which in turn impacted the SREP scores of several banks and their Pillar 2 capital requirements.

The report highlights various regulatory initiatives to tackle enduring limitations with testing exercises due to conceptual uncertainty, data issues and modelling limitations.

Firstly, the report documents a growing move by regulators to standardise and increase the role for mandatory disclosures of corporate ESG metrics. Walther cites key initiatives such as the proposed ISSB climate-related disclosure standard, the EU’s corporate sustainability reporting directive, and the climate disclosure rules proposed by the Securities and Exchange Commission in the US.

Secondly, Walther states that despite existing capacity issues, banks are building their capabilities. Although the ECB’s stress tests showed that 40% of the 104 participating banks did not have a framework in place, Walther says that “almost all banks without a climate stress-testing framework aim to develop one over the coming years”. A key area identified for improvement is for banks to integrate CSTs into internal capital adequacy assessment and stress-testing frameworks.

Finally, in parallel to CSTs, supervisors are urging banks to integrate climate risks into their strategy, governance and risk management practices. The report highlights guidelines that have been proposed by financial supervisors, such as the Federal Reserve, the Basel Committee and the ECB. Though implementation flaws were found at most banks, the report also reveals “visible progress” in this area, citing a review that found 85% of supervised banks currently address the ECB guide.

Despite differences in the approaches and scope of stress tests included in the study, bank credit losses in a disorderly transition were consistently found to be higher than in an orderly transition, and even higher in a “hothouse world” with unabated global warming. Stress testing also found that strong capital buffers will help banks to absorb losses, but tail risks “may not be manageable” and there is a danger of underestimating climate risk under existing frameworks.