Explainer-Why are bank regulators struggling with climate stress tests?

By Simon Jessop and Huw Jones

LONDON (Reuters) – The first stress tests to assess banks’ exposure to the risks of climate change are underestimating the worst-case scenario, the European Central Bank and Bank of England have said, underscoring the challenge of making such exercises more useful.

The banking regulators say the tests are needed to assess vulnerabilities in the financial system from climate change-driven catastrophes, be they in the banks’ loan portfolios, trading books or customer accounts.

Here is why regulators, investors and banking experts say climate stress tests are still a work in progress but improvements are on the way:

CLIENT DATA

For a bank to understand the climate risks embedded in their financing, they need access to accurate data from clients, including their current emissions and the plan to reduce them over time. While regulators in the European Union and elsewhere are starting to push companies in the real economy to provide this data, it remains early days and banks have had to rely on estimations. The approaches taken by banks to fill in the gaps in data also vary.

Tougher, mandatory climate disclosure rules for companies in the European Union, Britain, the United States from 2024 onwards will plug gaps in emissions data from customers of banks, giving a far more accurate picture of exposures. “The disclosure tool will be a bit of a game changer,” said Monsur Hussain, senior director at credit ratings agency Fitch, meaning climate tests will “get more stressful” for banks.

BALANCE SHEET CHANGES

The lending decisions made by banks over time determine the risk on their balance sheet, yet modelling this is hard. A static balance sheet, which assumes no change over time, is unrealistic, yet a dynamic balance sheet requires many assumptions to be made, which could be equally wrong.

Regulators say they expect the modelling to improve over time, while the process will help lenders and policymakers develop the mindset, knowledge and skills needed to come up with better tests for making decisions in future.

“Asking them to do that preparation and asking whether they are or aren’t prepared, is a really important question,” said David Carlin, climate risk programme lead for the UNEP Finance Initiative, a joint UN and finance industry initiative.

FEEDBACK LOOPS

While the initial stress tests have taken into account macroeconomic and financial variables, for example the imposition of a higher carbon price through government policymaking, they do not capture all of the potential risks associated with climate change, such as climate-related litigation, and, equally as important, how these differing risks will interact with one another.

TIME HORIZON

Traditional financial stress tests, introduced after the financial crisis of 2008-2009, typically focus on resilience to shorter-term shocks to a bank’s solvency, and are more closely aligned to a lender’s planning horizon of 2-5 years. Climate stress tests, on the other hand, tend to focus on risks that may play out over decades into the future with data covering such lengthy periods patchy at best.

(Reporting by Huw Jones and Simon Jessop in London; Editing by Greg Roumeliotis and Hugh Lawson)

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