European banks ignore climate in credit models despite short-term risk, says ECB

European banks are vulnerable to short-term weather-related credit risks, but most institutions have yet to include weather in their credit risk models, according to the European Central Bank.

Four out of five institutions do not consider climate risk as a variable when granting loans, the ECB said.

Banks participating in the ECB’s prudential climate stress test forecast an increase in cumulative credit impairments of around 73 basis points of total risk exposure over the next three years in the event of a sharp rise in the price of carbon emissions.

Carbon-intensive sectors, such as refined petroleum products, mining, minerals and ground transportation, account for most of the losses. These sectors recorded cumulative credit write-downs of more than 200 basis points, the ECB said.

The numbers are likely to be higher in reality, according to the regulator. He said the projection made by the banks “significantly underestimates the real climate-related risk” and reflects “only a fraction of the real danger”. The test suffered from the scarcity of available data and limitations in modelling, scope and scenarios, he added.

The full ECB exercise also revealed that banks are ill-equipped to assess climate risks. About 60% of European financial institutions do not have a climate risk stress-testing framework in place, and most banks do not include climate risk in their credit risk models. Only 20% of banks consider climate risk as a variable when granting loans, he found.

A total of 104 eurozone banks took part in the exercise, including 41 in the bottom-up stress test in which institutions had to make loan loss projections under different scenarios. He found that banks faced “a non-negligible increase in credit risk” in his “near-term disorderly transition scenario”, which assessed European banks’ vulnerabilities to climate risk between 2022 and 2024.

A “sharp and abrupt increase in the price of carbon emissions”, coupled with floods and droughts, could lead to cumulative losses of around 70 billion euros for the 41 banks by 2024, the ECB has found. The regulator did not disclose the carbon price used to make such an assessment.

The banks also made loan loss projections when faced with three different climate scenarios over a 30-year horizon. An orderly scenario assumes early and ambitious action to achieve a net-zero emissions economy by 2050, while a disorderly scenario assumes action to reduce emissions is late, disruptive, sudden, and/or unplanned. The most severe “greenhouse world” scenario assumes limited action to reduce emissions, leading to a world with significant global warming.

Here, the banks plan loan losses between 16.5 bps and 19.5 bps perform exposures as part of the test. This “relatively low number” in the long-term scenarios was caused by the methodology, which assumed a dynamic approach to the balance sheet, said Frank Elderson, vice-chairman of the supervisory board of the European Central Bank, during a point Press. This means that banks were allowed to project how their balance sheet will change under changing circumstances and as such adjust the portfolio that was tested in the exercise.

Capital impact

The test could have an indirect impact on banks’ Pillar 2 requirements this year, said Elder, as the results will feed into the Supervisory Review and Evaluation Process, or SREP, and may affect the rating of banks’ business models, internal governance or risk management. SREP assesses how a bank manages risks and factors that could adversely affect its capital or liquidity, and helps supervisors determine an institution’s Pillar 2 capital requirements or guidance.

The ECB said the stress test is not a capital adequacy exercise, but described it as a “learning exercise for banks and supervisors”. The aim is to identify vulnerabilities, best practices and challenges that banks face in managing climate-related risks.

Elder suggested that climate stress testing would grow in importance and could have a more direct impact on capital requirements in the future.

“As with all material risks, climate-related factors will eventually be incorporated into our risk-based oversight approach,” he said.

The Bank of England recently carried out a climatic stress test on Britain’s biggest banks and also highlighted gaps in lenders’ preparedness and ability to measure climate risk.

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