Banks are vulnerable to damage from climate change, which could particularly affect their balance sheets and asset holdings. Banks in southern Europe are more vulnerable than average: they face increased physical risks for more than 60 per cent of their corporate loans. Transition risks mainly involve loans to carbon-intensive sectors, which are included in the portfolios of a limited number of banks.
A recent study by Deutsche Bank on climate stress tests questions if banks are fit for the green transition. “The materialisation of climate risk can have a sizeable impact on bank profitability,” the authors concluded. Stress tests by the European Central Bank and Bank of England suggest credit losses could rises as much as 50 per cent by the year 2050, pushing down profits by between 10 and 15 percent.
According to the authors of the study, climate risks have a time horizon of up to more than 30 years. The problem, they noted, is that there are significant gaps in the dataset. Furthermore, legislators have high requirements for capital buffers because of potential climate risks due to higher-than-calculated global temperature.
At present, climate stress tests do not yet affect capital requirements, with the exception of EMU Pillar 2. The ECB however requires banks to set up climate risk management. According to Deutsche Bank, recent research shows that 67 stress tests have been done globally; the Federal Reserve is going to do one this year.
Fires and floods
Deutsche’s research shows that the main fears are both executive physical risks for banks and transit risks. Forest fires and floods make loans to non-financial corporations (NFC) particularly risky. It is mainly the big banks that have excessive exposure to carbon-intensive sectors.
Forest fires and floods in particular can cause bank customers to fail. At the same time, people are increasingly looking at climate stress tests, which have a very long time horizon of some 30 years. The scenarios assume “an orderly transition”, “a disorderly transition” and a “hot house world”. In the latter two cases, the damage to NFC loans would be 10 to 13 per cent on the loan portfolio. The Bank of England previously assumed 30 per cent damage to the loan book in a “hot house world” scenario. From ECB research, 41 participating banks estimated credit and market risks totalling 70 billion euros in short-term damage.
Deutsche Bank argues, based on the information now available, that climate risks could have quite an impact on banks’ profitability. Furthermore, banks should be able to absorb climate-related losses based on their strong capital buffers. Limitation of current stress tests is that there is high complexity and deep uncertainty, and gaps in the dataset are large. Also, modelling to estimate risks is very difficult.
Stress tests in the field of climate change are in their infancy. In an ECB stress test last year, 40 per cent of the 104 participating banks stated that they have set up a framework for stress testing. The ECB has set a deadline for supervised banks to have a climate risk management system in place by 2024.