European banks are building their risk models to better prepare for the fallout from climate change, with some even exploring the short-term liquidity implications of a warmer planet, according to in a joint survey conducted by the Association for Financial Markets in Europe and Oliver Wyman.
The analysis, published on Thursday, found that 87% of the banks surveyed have started to conduct their own annual internal climate stress tests, in some cases using modeling beyond the requirements set by regulators. That’s amid a general consensus that past exercises underestimate real risks, the survey found.
The results show that banks are increasingly concerned about the potential for global warming to damage asset values. The industry also faces a December deadline by the European Central Bank to reflect climate risks in their governance, strategy and risk management.
Credit risk is the biggest concern, especially for banks exposed to the fossil-fuel sector and for lenders with large loan books. The analysis also revealed that some banks are trying to map out how they would fare in scenarios where the fossil-fuel sector rapidly devalues, as they build their models.
“While initially focused on credit risk and market risk, the banks that responded to the survey shared that they expanded the scenario analysis to operational risk and explored the possibility of covering additional types of risk,” said AFME Chief Executive Officer Adam Farkas in the report, which is based on an analysis of 15 banks representing close to €15 trillion ($16.4 trillion) in combined assets.
New areas of concern include business liquidity as well as interest rate risk in the banking book, he said. In fact, about a third of the banks surveyed said they already modeled for such risks, the survey showed.
At the same time, only about a third of the banks surveyed said that they currently consider it “relevant” to discuss strategies with clients to mitigate climate risks.
The report by AFME and Oliver Wyman found that a climate stress test carried out by the ECB in 2022 likely underestimated the real risks associated with a warmer planet. The landmark exercise was slower than many in the industry expected, and did not disclose losses that would have left a meaningful dent in capital buffers.
The ECB’s trial was a “valuable learning exercise,” the report said. However, the industry now needs better guidelines to help banks prepare for the wider range of climate risks identified, it said.
“While the ECB’s good practice guidance is a useful starting point, additional supervisory guidance on how banks should build their internal stress testing and modeling capabilities will help drive greater consistency in the industry, ” the report said.
EU regulators are due to provide an update later this year on the ways in which ESG risks can be integrated into banks’ capital requirements. Researchers at the Bank for International Settlements said as early as 2023 that industry watchdogs lacked the tools to prevent climate change from disrupting the financial system.
Photo: The exposed riverbed of a dried-up tributary of the River Danube in Bratislava, Slovakia, on Monday, Sept. 5, 2022. Photo credit: Michaela Nagyidaiova/Bloomberg
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