- SUPERVISION NEWSLETTER
In the spotlight: 2022 supervisory climate stress test
16 November 2021
Stress tests are a powerful tool for supervisors to assess whether banks are resilient enough to withstand financial and economic shocks. The ECB conducts supervisory stress tests annually, in line with Article 100 of the Capital Requirements Directive. In years without a European Banking Authority EU-wide stress test, the ECB conducts a targeted stress test exercise focusing on a specific topic of interest, such as the sensitivity analysis of interest rate risk in the banking book in 2017 and the sensitivity analysis of liquidity risk in 2019.
The ECB’s Supervisory Board has selected climate risk as the focus of the 2022 supervisory stress test exercise, given its increasing significance to the supervisory agenda. The exercise will be complemented by a full supervisory review of banks’ climate-related and environmental risk management practices, which will seek to comprehensively assess how banks have incorporated these risks into their strategy, governance and risk management frameworks and processes.
The ECB considers the stress test to be a learning exercise for banks and supervisors alike. It aims to identify vulnerabilities, best practices and the challenges banks are facing in relation to climate-related risk management. The exercise will also help enhance data availability and quality, and will allow supervisors to better understand the stress testing frameworks banks use to gauge climate risk. When deciding on the methodology, ECB Banking Supervision sought to strike a balance between the objective of accelerating bank action on climate risk and that of conducting a robust stress test exercise.
In this spirit, the output of the stress test exercise will be integrated into the Supervisory Review and Evaluation Process (SREP) using a qualitative approach. In other words, there will not be a direct capital impact via the Pillar 2 guidance. A possible impact of the exercise – if any – will be indirect, via the SREP scores on Pillar 2 requirements.
The 2022 supervisory climate stress test has a modular approach comprising three distinct modules:
- Module 1: a questionnaire to qualitatively assess banks’ internal climate risk stress test frameworks. This will help supervisors understand whether banks’ capabilities are sufficiently developed.
- Module 2: a peer benchmark analysis of two climate-related metrics. Metric 1 assesses the sustainability of banks’ business models by measuring their income from climate-relevant exposures, such as loans to industries emitting large volumes of greenhouse gases. Metric 2 assesses the extent to which banks are exposed to carbon-intensive industries based on greenhouse gas emissions and loans at the counterparty level.
- Module 3: a bottom-up stress test targeting transition and physical risks. Banks will submit starting points and their own projections based on the ECB’s common methodology and pre-defined scenarios for credit and market risk. The projections will be complemented by a qualitative assessment of operational and reputational risk.
To acknowledge that banks differ in their levels of preparedness, only a subset of banks will be required to submit projections under Module 3. All banks subject to Modules 1 and 2 will need to submit starting points under Module 3.
For Module 3, the ECB will provide macro-financial scenarios to ensure that banks use common assumptions about key macroeconomic and financial variables. These variables will be calibrated using ECB economy-wide stress test models and are largely based on scenarios prepared by the Network of Central Banks and Supervisors for Greening the Financial System. Supervisors will then challenge banks’ starting points and projections to ensure a level playing field.
For transition risk, the stress test focuses on the potential impact under both short-term and long-term scenarios. First, it assesses banks’ short-term vulnerabilities in a three-year baseline scenario that assumes a static balance sheet and a disorderly transition to a low-carbon economy, triggered by a sharp increase in the price of carbon emissions. Second, it assesses banks’ longer-term strategies when confronted with three different transition scenarios over a 30-year horizon, assuming a dynamic balance sheet. Focusing on these long-term strategies has two main benefits: it will encourage banks to better project risk parameters over the long run and it will help supervisors understand how banks would strategically tailor their business mix when adjusting to transition effects.
The assessment of physical risk will focus on two extreme weather events representing key climate risks in Europe: (i) a large flood and (ii) a severe drought and heatwave. To keep the exercise manageable and aligned with its learning objective, the methodology focuses on the acute nature of physical risk over a one-year time horizon, assessing the impact on credit risk only.
The 2022 supervisory stress test targets specific asset classes relevant for the climate agenda rather than looking at banks’ balance sheets in their entirety. Therefore, while the structure of the ECB’s 2022 supervisory stress test exercise is based on established stress test methodological approaches used by the industry, the approach has been adapted to focus on climate-related breakdowns of exposures and income. The stress test, including its methodology and scenarios, is a hypothetical exercise with specific limits, i.e. so as to be manageable at the operational level, it does not seek to capture every single aspect of climate-related risk.
The ECB acknowledges that banks will encounter challenges during the exercise owing, for example, to scarce data availability, complex internal reporting systems and the lack of common disclosure requirements for climate risk. Moreover, climate risk frameworks are still being developed. To alleviate the pressure on banks and to reflect the fact that it is a joint learning exercise, the ECB only plans to publish the aggregate findings of the 2022 supervisory exercise – it does not intend to publish results for individual banks.
The 2022 supervisory climate stress test will help develop the response to a critically important issue and will lay the groundwork for a much-needed transformation process in banking and supervision. It will act as a catalyst to improve data quality and stress testing capabilities and will complement ECB Banking Supervision’s other climate-related initiatives, such as its assessment of banks’ climate risk management practices and action plans to meet supervisory expectations. Further information will be shared as the preparations for the stress test are finalised. The stress test methodology and templates were published in the middle of October and the scenarios will follow in the first quarter of 2022. Publication of the aggregate results is planned for the third quarter of 2022.