The ECB warns that banks do not sufficiently incorporate climate risk in their internal models

The potential losses for the 41 banks that completed the entire stress test would amount to 70,000 million

MADRID, 8 Jul. (EUROPA PRESS) -

Banks have not yet sufficiently incorporated climate risk into their stress-testing frameworks and internal models, despite some progress since 2020, the European Central Bank (ECB) said following stress-test results. to which it has subjected 104 entities, although only 41 completed the stress test, which estimated an adverse impact of 70,000 million in relation to a sharp increase in carbon prices, droughts and floods.

In this regard, the central bank highlighted that banks managed to report comprehensive and innovative information on climate risk, although it regretted that most entities do not have robust frameworks for climate risk stress tests and lack relevant data.

"Euro area banks must urgently step up efforts to measure and manage climate risk, closing current data gaps and adopting good practices that are already present in the sector," said Andrea Enria, Chairman of the Supervisory Board. of the ECB.

A total of 104 significant banks participated in the test, which consists of three modules, although in the third, the 'bottom-up' stress test was limited to 41 directly supervised banks to ensure proportionality towards smaller banks .

In the first module of the review, banks provided information on their own climate stress testing capabilities, while in the second they indicated their reliance on carbon-emitting sectors, and in the third their performance under different scenarios over time was assessed. of various time horizons.

"This exercise is a crucial milestone in our journey to make our financial system more resilient to climate risk," said Frank Elderson, Vice Chairman of the Oversight Board. "We expect banks to take decisive action and develop robust climate stress testing frameworks in the short to medium term," he added.

The results of the first module of the exam show that around 60% of banks still do not have a climate risk stress testing framework in place. Similarly, most banks do not include climate risk in their credit risk models, with only 20% considering climate risk as a variable when making loans.

In this regard, the ECB warns that banks currently fall short of best practice, according to which they should establish climate stress testing capabilities that include various climate risk transmission channels (for example, market and credit risks). and portfolios (for example, corporate and mortgage).

In the second module of the test, the results indicate that, in aggregate, nearly two-thirds of banks' revenues from non-financial corporate clients come from greenhouse gas-intensive industries.

In many cases, the ECB notes, banks' "funded issues" come from a small number of large counterparties, increasing their exposure to transition risks. Likewise, the institution recommends that banks intensify their commitment to the client to obtain more precise data and information on their transition plans, since it is a precondition for banks to measure and manage their exposure to climate risks in the future. future.

As for the stress test of the third module, which requires banks to project losses in extreme weather events and in transition scenarios with different time horizons, it confirms that physical risk has a heterogeneous impact on European banks.

In this way, the findings show that the vulnerability of banks to a drought and heat scenario depends to a large extent on the sectoral activities and the geographical location of their exposures, materializing its impact through a decrease in sectoral productivity, as for example in agricultural and construction activities, and an increase in credit losses in the affected areas.

Similarly, in the flood risk scenario, real estate securities and underlying mortgages and corporate loans are expected to suffer, particularly in the hardest-hit locations.

The stress test shows that credit and market losses in a short-term disorderly transition and the two physical risk scenarios amount to around €70 billion combined for the 41 banks in question.

Specifically, some 53,000 million euros would correspond to losses recorded under the short-term disorderly transition scenario and another 17,000 million to losses recorded in short-term physical risk scenarios, such as droughts or floods.

However, the ECB warns that "this significantly underestimates the real risk related to climate", since it reflects only a fraction of the real danger, due to the scarcity of available data at this early stage, the model underlying the projections of banks that only rudimentarily captures weather factors, excluding economic downturns and spillover effects from scenarios, that the exposures examined only account for about a third of the total of the 41 banks.

Regarding the long-term projections of banks under different climate risk scenarios, the results show that an orderly green transition translates into lower losses than a disorderly or null policy action.

However, the ECB highlights that banks hardly differentiate between various long-term scenarios as they lack solid strategies, beyond the tendency to reduce exposures from the most polluting sectors and support businesses with lower carbon emissions. Therefore, banks must consider direct and indirect transmission channels in their long-term strategic plans.