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FAQs for the 2022 climate risk stress test

Why is ECB Banking Supervision conducting a climate risk stress test?

Climate change poses an increasing risk for banks and the European financial system as a whole.

The 2022 climate risk stress test (CST) assesses how well banks are set up to deal with climate-related risks. To do so, the exercise is looking at banks’ climate risk stress testing capabilities and comparing participating entities across a common set of climate risk metrics. It also includes projections for different scenarios targeting specific transition and physical risks.

This exercise is not a typical capital adequacy stress test. It is a learning exercise aimed at identifying vulnerabilities and best practices and providing guidance to banks for the green transition.

Which climate-related risks does the exercise cover?

The exercise evaluates aspects of both physical and transition risks.

The assessment of physical risk focuses on two extreme weather events: a major flood and a severe drought over a one-year time horizon.

For transition risk, the test includes several scenarios and time frames. First, it assesses banks’ short-term vulnerabilities in a three-year baseline and a disorderly transition scenario, triggered by a sharp increase in the price of carbon emissions.

Second, it looks at their longer-term strategies in the face of three different transition scenarios over a 30-year horizon. The exercise considers the impact of transition risk from credit, market, operational and reputational risk standpoints as well as from a qualitative perspective.

What kind of information have banks reported to the ECB?

Banks have submitted a full set of templates, covering the three modules of the exercise and the underlying calculations, together with an explanatory note describing the approaches they’ve taken when completing the exercise. For instance, banks were asked to report, for the first time ever, their revenue dependency on greenhouse gas intensive industries and the emissions from the fossil fuel companies financed by them.

How does the ECB interpret the results of the test?

The results of the CST show that we’re at the start of a long journey. Banks have made some progress in incorporating climate risk stress testing frameworks, but there’s still plenty of room for improvement.

One of the things that banks need to do to be better prepared for the green transition is to step up their customer engagement to overcome their data availability challenge.

Has the ECB identified any lessons learnt?

A very important feature of this exercise is its learning outcome for banks and supervisors alike. To ensure that banks can benefit from all the insights gained from the CST, we intend to share the resulting best practices in the third quarter of 2022. Overall, it is crucial that banks obtain better data from their customers and rely less on proxies to estimate their exposure to carbon intensive sectors. Moreover, they should establish climate stress testing capabilities that encompass several climate risk transmission channels (e.g. market and credit risks) and portfolios (e.g. corporate or mortgage).

How will the ECB use the results?

The results of the CST will feed qualitative elements into the Supervisory Review and Evaluation Process (SREP). This means that results could have an indirect effect on Pillar 2 capital requirements through SREP scores. However, there will be no direct impact on capital through Pillar 2 guidance in 2022.