In August of last year, during a demonstration organized by Fridays for Future in Frankfurt, Germany’s financial district, environmental protesters took to the streets.
The results of the first stress test on climate risk conducted by the European Central Bank reveal that most banks do not adequately account for climate risk in their internal models and stress-testing frameworks.
The ECB stated in a report released on Friday that the results “reaffirm the view that banks should sharpen their focus on climate risk.”
Andrea Enria, chair of the ECB’s supervisory board, said in a statement that “Euro area banks must urgently step up efforts to measure and manage climate risk, closing the current data gaps and adopting good practices that are already present in the sector.”
The ECB reported that 104 banks altogether took part in the test, which was the first of its kind, and provided data across three modules, or categories. These included their own capacity for conducting climate stress tests, their reliance on industries that emit carbon, and their performance under various scenarios over a range of time horizons.
According to the first module’s findings, about 60% of banks do not yet have a framework for stress-testing climate risk.
Similar to this, according to the ECB, only 20% of banks take climate risk into account when making loan decisions and the majority do not include it in their credit risk models.
Concerning banks’ reliance on carbon-emitting industries, the ECB noted that, overall, almost two-thirds of banks’ revenue from non-financial corporate customers comes from sectors that produce a lot of greenhouse gases.
The report discovered that banks’ “financed emissions” are frequently generated by a small number of sizable counterparties, increasing their exposure to emission-intensive industries.
To ensure proportionality toward smaller banks, the results for the third module were restricted to the 41 directly supervised banks. Lenders were obligated to forecast losses from extreme weather events under various transitional circumstances.
The findings indicated that for the 41 directly supervised banks, credit and market losses could total around 70 billion euros ($70.6 billion) this year.
However, the ECB noted that because this only reflects a small portion of the actual hazard, it “significantly understates the actual climate-related risk.” This was caused, in part, by the dearth of information.
According to Frank Elderson, vice-chair of the ECB supervisory board, “this exercise is a crucial milestone on our path to making our financial system more resilient to climate risk.” “We anticipate banks to act swiftly and create solid frameworks for conducting short- to medium-term climate stress tests.”
In a previous statement, ECB President Christine Lagarde stated that the institution was working to integrate climate change “into our monetary policy operations.”
The ECB claimed it gathered both qualitative and quantitative data in order to evaluate the sector’s preparedness for climate risk and compile best practices for managing climate-related risk.
The report came to the conclusion that most banks would need to do more work to enhance the governance, data accessibility, and modeling methodologies of their stress test frameworks.