In partnership with global management consultancy Oliver Wyman, the Association for Financial Markets in Europe (AFME) has published a report discussing the progress of EU banks around climate risk stress testing.
The paper, ‘A Common Path to improve European Climate Risk Stress Testing and Scenarios Analysis’, reports that, following the most recent ECB climate risk stress testing exercises, banks have developed sophisticated approaches to internally understand and analyse climate risks.
It also outlines five major challenges around climate stress tests for EU banks. The first of these is scope, with a lack of materiality thresholds meaning that banks are unsure whether their stress tests are covering areas that are not materially affected by climate risks, such as market risk.
Of the banks surveyed by AFME, 87 per cent agreed that materiality thresholds need to be defined based on exposure and climate riskiness before further stress tests are conducted, in order to more effectively determine which portfolios will be more impacted.
The second challenge is a lack of, or poor, data quality. AFME states that data is considered “the most important tools to accurately assess and understand the plausibility and severity of climate risks across financial risk types,” and without access to sufficient data firms are limited in their ability to project and respond to climate risks. Currently, all those surveyed rely on external data providers for climate data, and 87 per cent do so for physical risk data.
AFME’s research states that banks are hoping to see time horizons shorten in future stress test scenarios. This will allow them to make more realistic climate shock predictions that are in line with capital planning and risk management, the organisation says.
The scenarios used in stress tests are also in need of development, according to the report. 67 per cent of banks surveyed said that a lack of short-term scenarios, insufficient regional granularity for key scenario variables and inadequate scenario variables are the most limiting factors in the NGFS’ system. As this is the most commonly used baseline for the determination of transition and physical risks, these are key areas for development.
Banks are also facing challenges in how to integrate climate risks into existing risk parameters across risk types. A fifth of those surveyed affirmed that although they are exploring the impact of climate risk on other financial risk types, these are not yet being considered within European supervisory climate stress tests.
The report was conducted with the participation of regulatory and supervisory authorities, including the ECB, EBA and the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), and 15 of AFME’s member banks.
Constance Usherwood, managing director of prudential regulation at AFME, says: “Climate change remains a shared concern and priority for banks, their clients and financial authorities. While there are challenges ahead, collective efforts to improve climate risk stress testing methodology will be essential to further understand climate change patterns and their impact on the economy. ”
Radka Margitova, partner in the finance and risk division at Oliver Wyman, adds: “With the survey revealing that most participating banks are now conducting annual internal climate stress tests, exceeding the biannual regulatory requirement, it signals the importance placed on climate risk in the financial sector.
“Coupled with banks' efforts to incorporate more comprehensive risk metrics into their climate stress testing, it marks a significant advancement in financial institutions' approach to climate change, driving the development of more robust risk management frameworks and contributing to wider societal efforts to mitigate climate impacts.”
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