Too much too fast? The ECB's climate stress test demands will challenge banks

Building effective, credible stress-testing frameworks in house may be too big an ask of firms that are just getting to grips with their climate risks

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Testing times lie ahead for European banks. In a comprehensive guidebook published last week, the European Central Bank (ECB) explained how it wants lenders to identify and manage their climate-related risks. Among its list of expectations, the agency said firms should run internal stress tests to measure and monitor their financial exposures.

The ECB believes these will help banks assess the resiliency of their business models, get a sense of the potential impacts to their market risk positions and future investments and — perhaps most consequentially — see how climate risks could challenge their capital adequacy.

Though the guidelines do not have the same force as binding regulations, the ECB has published them on a ‘comply-or-explain’ basis, meaning that from end-2020 it will want to know if “significant institutions” (big banks) diverge from its expectations. Importantly, a bank that doesn’t respect the guidelines could receive a black mark in its annual supervisory review, which may in turn result in a Pillar 2 capital add-on.

Climate change is coming, look busy

That should be enough stick to convince lenders they need to get building climate risk stress-testing frameworks — and fast. Many will be working from a standing start. A survey of top banks by the consultancy Mazars found that 12 out of 30 do not have climate scenario analysis in place, and the ECB itself admits that few institutions have included climate-related risks in their stress testing to date.

What’s more, the central bank says these tests should be tailored to lenders’ own risk profiles. For example, the ECB says that stress tests to gauge capital adequacy should use “institution-specific” adverse scenarios. Cookie-cutter simulations and off-the-shelf parameters simply won’t do.

Bootstrapping a climate stress-testing framework that’s fit for purpose and aligned with European supervisory standards by year-end, with all the pressures of the coronavirus crisis to deal with, may prove too much for some. But certain shortcuts are available that could help struggling firms get the basics right.

For starters, there’s a wealth of stress-testing models, assumptions and scenarios out there that could serve as templates to build upon. A bunch of eurozone regulators have already subjected their supervisees to climate-related stress tests. The Dutch National Bank (DNB), for instance, conducted an energy transition stress test in 2018 to weigh up financial institutions’ vulnerabilities to the migration to a net-zero carbon future. 

The Banque de France has also announced climate stress tests for supervised banks and insurers, and the agency’s economists recently published a climate change scenario tool that can be used to assess the effects of an energy transition price shock.

These could serve as blueprints for firms working on their in-house stress-testing frameworks. For example, the four energy scenarios cooked up by the DNB could be adapted by banks elsewhere in the eurozone to test their vulnerability to transition risk. Climate change scenarios from outside the banking industry could also be put to work. The UN’s Intergovernmental Panel on Climate Change, for instance, has developed Representative Concentration Pathways scenarios for projecting the physical risks of climate change.

Scenarios are one thing, expressing them as a series of macroeconomic variables to stress a balance sheet with is another. Fortunately, the financial industry is not lacking for models that can be deployed for this purpose. Many are even open source, and can be tweaked to suit the needs of the user.

The Massachusetts Institute of Technology’s Economic Projection and Policy Analysis Model (EPPA) is one such tool, which can be used for non-commercial purposes by private companies. The Bank of Canada used this model to assess the global GDP and sectoral impacts of several different climate change scenarios for a recent research paper.

Then there’s the Paris Agreement Capital Transition Assessment (PACTA) model, developed by the 2° Investing Initiative and supported by the UN Principles for Responsible Investment. The methodology and source code are freely available, and a number of banks, including ABN Amro, have successfully used the tool to produce scenario analyses.

Move fast and break things?

Resources like these mean that banks don’t have to start from scratch when building out their stress-testing frameworks.  Still, fulfilling the ECB’s expectations may be too much of a stretch for some. After all, it’s not as though European banks had a glowing record on stress testing to begin with. The ECB’s 2019 Supervisory Review and Evaluation Process (SREP) of top firms found weaknesses in their stress-testing frameworks, and some significant institutions underestimated their 2018 losses in the European Banking Authority’s industry-wide tests.

The end-2020 deadline for adherence to the guidelines adds another layer of difficulty. A bad outcome would be that firms, struggling to meet this deadline, take a slapdash approach to scenario construction and the testing process. The result? Poorly-performed tests that shed little light on the true nature of their climate risks. 

The International Institute of Finance (IIF) warned of this effect back in March in the context of the Bank of England’s proposed climate stress tests. The trade body said that because these go “well beyond what financial institutions have done so far in a supervisory or public context” they could push firms too hard, too soon, and compromise “the quality and therefore the value” of firms’ submissions. 

Even worse, bad stress tests could be “gamed” to avoid an adverse result. Some banks may be tempted to downplay their climate risks to avoid a capital add-on, and lowball their loss estimates accordingly. For example, a firm could use a climate change scenario that only slightly affects their portfolio, or bake in unrealistic assumptions about how fast it could adapt its business model.  Doing so would go against the principle that these tests be “institution-specific”, but if the ECB is not up to the task of properly scrutinising each firm’s scenarios, assumptions, and key variables, a bank could get away with it.

It’s certainly right that the ECB is asking banks to invest in climate stress-testing capabilities. The nature of climate risk is such that forward-looking approaches are needed, since historical precedents don’t exist. But the danger is that by asking firms to do too much, too fast, the ECB pushes them down the wrong path. Instead of slowly and smartly integrating climate risks into their stress-testing frameworks, banks may choose to simply ‘bolt-on’ a module or overlay a generic climate change scenario that pays lip-service to the guidance while doing little to further their understanding of their vulnerabilities. 

Industry-wide, supervisor-set stress tests may be a better way to benchmark firms’ climate risk exposures. Yes, there are downsides to using a uniform set of scenarios and assumptions. Some banks may only be slightly affected by such tests while others incur devastating losses. But at least the tests could be designed to a high standard and the variables and assumptions would be in the gift of regulators.

European authorities, and individual member state regulators, are already putting such tests together. Why not work to ensure banks have the capabilities in place to run these tests effectively, instead of pushing them to develop their own in-house frameworks at the same time?

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