How central banks are assessing the resiliency of financial institutions to various climate scenarios

In recent months, there has been an increase in regulatory requirements and standards which larger companies are mandated to follow, across all three pillars of ESG. The impact of climate change on banks and insurance companies has been the primary focus of central banks in the UK, Europe and most recently in the U.S. Prospect Law’s Head of ESG, Jacqueline Faridani shares an overview of the analysis and results of these central banks which highlight the importance of factoring in climate risk to risk management frameworks going forward.

Which central regulatory bodies are carrying out climate resiliency testing?

Most recently, the U.S. Federal Reserve Board has announced the launch of a pilot climate scenario analysis with six large banks. The exercise is due to start in 2023 and conclude towards the end of the year. The announcement is the most recent in a series of measures introduced by regulators globally to help assess the resiliency of financial institutions to various climate scenarios. The banks participating in the US Federal Reserve Board exercise are Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, and Wells Fargo. The Fed’s exercise considers the impact of a series of climate, economic and financial scenarios on the financial stability of the institution.

The European Central Bank (ECB) has recently released results from their climate stress tests, which highlighted the urgency with which European banks need to incorporate climate risk into their risk management frameworks, while the Bank of England’s climate stress test results show that banks and insurance companies, while being able to absorb the transition and physical costs of climate change, will be strained financially.

The threat to financial stability

The U.S. Financial Stability Oversight Council (FSOC) released a report last year, identifying climate change as an emerging and increasing threat to financial stability in the U.S., highlighting the need for federal agencies to address this issue. The FSOC’s key recommendations included using scenario analysis to assess climate-related financial risks, as well as highlighting the need for new regulations to deal with these risks.

The Fed is also a member of NGFS, the Network of Central Banks and Supervisors for Greening the Financial System. This is a coalition of central banks, aiming at meeting the goals of the Paris Agreement, and enhancing the role of the financial system in managing risks and capital for low-carbon investments and sustainable development. It provides scenarios for stress tests used by the central banks. The scenarios reflect physical and transition risks, including possible future climate policies and increasing carbon prices. These stress tests are to be conducted in addition to the usual bank stress tests, which larger banks have conducted for some years.

UK: Bank of England’s Biennial Exploratory Scenario Analysis

In May 2022, the Bank of England announced the results of their climate risk scenario analysis, called the Biennial Exploratory Scenario (BES), based on a 30-year horizon. The scenarios used are based on those prepared by NGFS, and include an ‘early action’, ‘late action’ and ‘no additional action’, where the ‘action’ refers to achieving net zero. The first two scenarios, therefore, focus on transition risk to net zero, and the third on physical risk, arising from not taking any steps towards net zero.

What does this tell us?

The exercise indicated that large banks and insurers in the UK are likely to be able to absorb the costs of climate change, arising from both physical and transition risks. However, they will likely experience significant pressure from these effects, with losses of up to 10-15% of their annual profits. Credit losses for banks increase significantly under the ‘late action’ scenario and could be 30% higher than the ‘early action’ scenario, totalling an extra £110 billion of losses.

The long term impact of the 'no action' scenario

It is interesting to note that loss rates over the 30-year horizon under the ‘no action’ scenario were lower than the ‘late action’ scenario, but under the ‘no action’ scenario, the risks extended beyond 30 years and financial institutions will continue to experience additional losses after the 30-year time horizon. Under the other two scenarios however, the physical and transition losses from climate change, would have been brought under control by the end of the 30 years.

An additional danger from following the no-action scenario is that climate-vulnerable households and sectors would be particularly impacted. The test also indicated that climate vulnerable households and sectors would be particularly impacted. Their assets will be exposed to physical climate risk and would ultimately become very expensive to insure or uninsurable.

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Dr Jacqueline Faridani

Dr Jacqueline Faridani heads up Prospect Law’s fast growing ESG practice. She is an advisor in financial risk management with 20 years of experience in a variety of risk management, compliance and product control roles at Canadian, German, French and Russian banks and life insurance companies, as well as for the Canadian financial regulator (OSFI).

Prospect Law is a multi-disciplinary practice with specialist expertise in the energy and environmental sectors with particular experience in the low carbon energy sector. The firm is made up of lawyers, engineers, surveyors and finance experts.

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