Why are banking regulators struggling with climate stress tests?

Banking regulators say such tests are necessary to assess the vulnerabilities of the financial system to climate change-related disasters, whether in loan books, trading books or active checking accounts.

Here’s why regulators, investors and banking experts say weather stress tests are still ongoing, but improvements are on the way:

CUSTOMER DATA

For a bank to understand the climate risks inherent in its financing, it must have access to accurate data about its customers, including their current missions and the plan to mitigate them over time. While regulators in the European Union and elsewhere are starting to push real economy companies to provide this data, it’s still too early and banks have had to rely on estimates. The approaches taken by banks to fill data gaps also vary.

Tighter and more mandatory climate disclosure rules for businesses in the European Union, Great Britain and the United States from 2024 will fill gaps in bank client issuance data, providing a much brighter picture of accurate exposures. “The disclosure tool will change the rules of the game a bit,” said Monsur Hussain, senior director of the Fitch rating agency, meaning climate testing “will become more stressful” for banks.

CHANGES IN THE BALANCE SHEET

The lending decisions made by banks over time determine their balance sheet risk, but it is difficult to model. A static balance, which does not assume changes over time, is not realistic, but a dynamic balance requires many assumptions, which could be just as wrong.

Regulators say they expect modeling to improve over time, while the process will help lenders and decision makers develop the mindset, knowledge and skills to come up with better tests to make decisions in the future.

“Asking them to do this preparation and asking them whether or not they are prepared is a really important question,” said David Carlin, head of the climate risk program for the UNEP Finance Initiative, a joint UN and industry initiative. financial.

LOOP RESPONSE

Although the initial stress tests took into account macroeconomic and financial variables, such as the imposition of a higher carbon price through government policy, they do not capture all the potential risks associated with climate change, such as climate disputes, and equally important, how these different risks will interact with each other.

TIME HORIZON

Traditional financial stress tests, introduced after the 2008-2009 financial crisis, typically focus on resilience to short-term shocks to a bank’s solvency and are more closely aligned with a lender’s planning horizon of 2.5 years . Climate stress tests, on the other hand, tend to focus on risks that could manifest decades in the future, with data covering such long periods of time at best.

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