What Investors Want to Know: Bank Climate Stress Tests and Credit
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Sustainable Finance
Financial Institutions
EMEA
What Investors Want to Know: Bank Climate
Stress Tests and Credit
Pressure Builds to Strengthen Risk Management Capacities
Early Stress Tests Highlight Challenges
‘Regulators are generally using climate stress
Early findings from stress-testing exercises for banks and insurers
tests to better understand the organisational by a handful of regulators point to challenges of assessing losses
readiness of banks and insurers to manage from climate change many decades into the future. Gaps in data
these risks rather than absolute exposures. reporting from counterparties to banks remains a key challenge,
particularly with regard to understanding of physical risk exposure.
Qualitative findings from these exercises could
inform regulatory responses over time, Emerging issues, such as litigation risks, are starting to be
considered in scenarios, as are tail risks of a near-term disorderly
including capital charges.’ transition to better understand current exposures.
David McNeil, Director, Sustainable Fitch
Regulatory Response Start to Emerge
Most regulators are unlikely to directly integrate findings of climate
stress tests into capital charges or supervision, at least for now, due
to the weaknesses and uncertainties in underlying methodologies.
Nonetheless, other supervisory actions are likely to emerge, and
much of the value of climate stress-testing lies in understanding the
relative risk management capabilities of institutions for climate
change, and the risks posed to business model stability. Qualitative
findings from these exercises could prompt supervisory action in
some cases.
Risk Management Requires Better Data
The ECB’s assessment of practices in climate and environmental
risk management by EU banks pointed to some progress in credit
risk management integration, but this is occurring slowly and there
are prominent blind spots, notably around understanding of
Related Research physical risk exposures and understanding of the materiality of
Climate Change Stress Tests Are Becoming Mainstream climate risks within smaller eurozone banks. Moves towards
(March 2021) standardisation of reporting frameworks should be supportive, but
Benign Macro Stress Underpins Low Climate Change Impact for will take time to materialise.
French Banks and Insurers (May 2021)
Green Asset Ratios Shed Environmental Light on EU Banks’ Loans
and Investments (May 2021) Where Are Stress Tests Taking Place?
How Are Climate Stress Tests Likely to Affect Credit?
Are Banks Considering Climate in Credit Risk Management?
How Are Smaller Banks Managing These Risks?
What Impact Could Emerging Global Disclosure Standards Have?
Analysts
What Are the Implications of Financial Sector Climate
David McNeil Commitments at COP26?
Director, Sustainable Fitch
david.mcneil@sustainablefitch.com
Sustainable Insight │ 8 February 2022 sustainablefitch.com 1Sustainable Finance
Financial Institutions
EMEA
exercises, with both indicating that physical risks may dominate the
Where Are Stress Tests Taking Place? impact on credit profiles over longer timeframes, but pointing to
There is set to be a significant acceleration of climate stress-testing practical challenges in the measurement of these risks.
in 2022, building on early work by the Dutch and UK central banks,
as well as France’s Autorite de Controle Prudentiel et de Resolution The HKMA noted that, while banks should remain resilient to
(ACPR). climate-related shocks given their strong capital buffers, the use of
simplified assumptions and historical data to inform the exercise
means that real-world impacts on capital adequacy and credit could
Ongoing and Planned Climate Stress Tests
be significantly more severe. The capital adequacy ratio of the
Country Authority Timing domestic systemically important authorized institutions was
Australia Australian Regulatory End-2022 suggested to drop by 3% on average over the 5-year horizon under
Prudential Authority the disorderly transition scenario.
Brazil Banco do Central Brazil From July 2022 While transitional risks were measured in the HKMA exercise in
Canada Bank of Canada/Office of the Publication of pilot report terms of their impact on capital adequacy ratios, physical risk
Superintendent of Financial (‘Climate Scenario Analysis exposures were referred to in terms of absolute costs. The HKMA
Institutions Exercise’) January 2022
intends to undertake a similar exercise in two years’ time, whilst
Eurozone ECB From January 2022 banks work to strengthen their climate strategies and risk
France ACPR/Banque de France Publication of pilot report governance frameworks. The HKMA has indicated that it will work
June 2021 to help the industry address major gaps identified in the pilot
Hong Kong Hong Kong Monetary Publication of pilot report exercise, including those around data availability and assessment
Authority December 2021 methodologies.
Singapore Monetary Authority of End-2022
The US Federal Reserve is in the early stages of considering climate
Singapore
stress testing. In March 2021, the Fed announced the formation of
Malaysia Bank Negara Malaysia TBC 2022; draft published
a Financial Stability Climate Committee and Supervision Climate
December 2021
Committee, bringing together regulatory experts to better
UK Bank of England Publication of CBES findings understand sources of risk and identify steps to address these.
June 2022
Nonetheless more wide-ranging adoption of stress testing within
Source: Fitch Ratings the US banking system seems some way off.
The ECB recently launched its supervisory climate stress test of Researchers at the Federal Reserve Bank of New York published a
eurozone banks in January 2022, building on a broader exercise in report in September 20211 detailing how banks and the wider
September 2021 assessing the impact of three climate policy financial system could be supervised for climate-related financial
scenarios on the European banking system and corporates. Banks risks. The researchers proposed a metric based on the expected
will be required to submit their stress test templates to the ECB for capital shortfall of a financial institution in the event of a climate-
assessment from March 2022, although smaller banks will not be related shock.
required to provide their own stress test assessments. The stress- Using Citigroup (A/Stable) as a scenario, the paper suggested that a
test results are expected to be published by July 2022 and it has further USD73 billion would have been required to return its capital
been described as a learning exercise for regulators and banks. ratio to a safe level if the bank had undergone a climate stress
There are three core elements to the assessment: scenario in 2020.
• A questionnaire on banks’ existing climate stress-test
capabilities; How Are Climate Stress Tests Likely to
• A peer benchmarking exercise to assess the sustainability of Affect Credit?
banks’ business models and their exposure to emissions- The ECB’s economy-wide climate risk discussion paper in 2021
intensive industries; and highlighted systemic risks that could occur as a result of climate
• A bottom-up stress-testing exercise, which assesses the change, including erosion of the creditworthiness of counterparties
exposure of banks to severe physical and transitional climate as well as asset prices, with detrimental consequences for bank
risk scenarios in the near term. solvency. As such the forthcoming stress testing exercise is
expected to fall under the accountability of both bank chief risk
The Bank of England (BoE) launched its Climate Biennial officers and chief financial officers in most cases.
Exploratory Scenario (CBES) for banks and insurers in 2021, and
expects to publish aggregated results in May 2022. By end-2022, The ACPR notes that the exposure of French financial institutions
the BoE will set out its strategy for scenario analysis, drawing on to the sectors most affected by transition risk (such as mining,
supervisory and capital work and the CBES project. natural resources, oil and construction) is fairly low. However, the
contribution of these sectors to the rise in the cost of risk (e.g.
Elsewhere, Hong Kong Monetary Authority (HKMA) and Bank of provision to expected losses) is greater than their share of banks’
Canada recently published findings from their pilot stress-testing balance sheets – with the cost of risk rising threefold for these
1
https://www.newyorkfed.org/research/staff_reports/sr977
Sustainable Insight │ 8 February 2022 sustainablefitch.com 2Sustainable Finance
Financial Institutions
EMEA
sectors under a stress scenario. For context, the Covid-19 crisis in 2030s, “should that scenario come to pass” implying that capital
2020 led to a twofold increase in the cost of risk to French banks in charges are on the table.
a scenario of heavy business losses. Nonetheless, many banks
The ECB’s methodology is the also the first to address ‘conduct risk’
participating in the exercise pointed to difficulties in assessing
for banks, such as liability risks emerging from green products sold
market transition risk on a sectoral basis, with the ACPR suggesting
with underlying assets that do not match the promoted level of
this may have understated impacts.
greenness/sustainability. This highlights the ECB’s focus on
Some regulators have highlighted that capital requirements may governance aspects of climate risks for regulated banks as well as
ultimately be affected, owing to the high relevance of climate risk to the growing market focus on litigation risks from products
financial stability – ideally when banks have embedded processes marketed as green.
allowing them to better understand climate risks.
By contrast, the ACPR/Bank of France initial stress-test results
Challenges in terms of assessing credit risks include data gaps and have been criticised for presenting a fairly benign macroeconomic
still-emerging pathways for decarbonisation of specific economic backdrop for the duration of the stress scenario, with limited
sectors; carbon price assumptions, and their mapping to credit risk increases in unemployment or recessionary events over a 30-year
parameters and balance-sheet impacts, therefore rely on uncertain period.
methodological foundations. These challenges are compounded by
While the ACPR has adopted a dynamic balance-sheet model for
a lack of historical data for quality assurance of these exercises.
its stress test (assuming regulated banks increase or decrease
The global standard setter for banks, the Basel Committee on their exposure to certain activities on the basis of shifting risk
Banking Supervision (BCBS), recognises that existing financial risk profiles) the effects of this reallocation were seen to be muted
categories used by banks within the ‘Basel framework’ (credit risk, beyond the agricultural sector. A favourable picture was also seen
market risk, liquidity risk and operational risk) can be used to for the duration of the forecast with regard to access to and
capture the impact of banks’ climate-related exposures. affordability of insurance and reinsurance, which drew some
Nonetheless, the BCBS recognises that further analysis by criticism.
regulators may be needed to determine the adequacy of these
Polling of audience members during Fitch Ratings’ webinar on
measures to ascertain climate-related financial risks, and further
ESG in European Banks in November 2021 found that most
policies may be needed to address any gaps where identified.
participants felt that the climate stress-test findings published so
Most regulators are sensitive to these limitations and do not plan to far had provided little additional information on assets and
incorporate findings within supervision of bank capital geographies of heightened climate risks as data gaps remain too
requirements imminently, although other supervisory actions could large.
result from the findings of these exercises.
Both the BoE’s and Bank of France’s exercises required regulated
The BoE’s Prudential Regulation Authority has pledged to embed banks to provide their own data to support the assessment, pointing
climate change in its supervisory approach ‘from 2022’, and actively to the significant investments in data collection, assessment and in-
supervises companies in line with expectations published in 2019. house capacity building on climate risk management that will be
Banks are already required to hold capital against material climate needed to undertake more comprehensive assessments.
risks.
Fitch Poll: What Are the Key Takeaways from the Climate
The ECB has indicated that it takes climate-related risks into Stress Tests that Have Been Published So Far?
account when assessing capital adequacy for larger banks and that
it would factor in ‘qualitative findings’ of the stress tests when Limited additional information as data
gaps too big
assessing capital adequacy requirements and additional Pillar 2
charges within the Supervisory Review and Evaluation Process Limited additional information as
(SREP) scoring this year. We expect that any changes in capital scenario definition imprecise
charges arising from the SREP will not occur until at least January
2023. Outcomes provide valuable insight into
banks' relative exposure to climate risk
The underlying assumptions applied in the forthcoming ECB stress
test highlight the intent of supervisors: for example, the ‘Disorderly 0 20 40 60 80
(% of respondents)
Transition Scenario’ developed by the Network for Greening of the Source: Fitch Ratings
Financial System, which assumes a rapid increase in the price of
carbon around 2030 is brought forward to 2022-2024. The ECB This points to the current driver for promoting climate scenario
notes such a rapid, disorderly transition represents a tail risk, but analysis by regulators: not to identify specific geographical or asset
has the advantage of testing vulnerability of current exposures to class exposures among banks with any high degree of accuracy but
such a transition. rather to assess qualitatively capacities for decision-making and
risk management in relation to physical and transitional climate
Canada’s Office of the Superintendent of Financial Institutions risks.
(OFSI) in response to their climate scenario analysis exercise, has
noted that the OSFI will expect federally regulated financial
institutions to build up their capital buffers in the 2020s to be able
to weather an accelerated and volatile transition pathway in the
Sustainable Insight │ 8 February 2022 sustainablefitch.com 3Sustainable Finance
Financial Institutions
EMEA
some institutions are using exclusion or phasing out criteria to stop
Are Banks Considering Climate in Credit Risk or limit financing of certain activities.
Management? Almost all banks assessed are only partially, or not at all, aligned
Evidence from the ECB assessment of climate risk integration in with the ECB’s supervisory expectations on climate and
2021 shows some integration of climate considerations into credit environmental risk management. Internal reporting, liquidity risk
risk management in sectoral lending policies and client due management and stress-testing were identified as areas of
diligence, but limited applications to collateral valuations, risk particular deficiency. The ECB indicated that, while institutions
classification or loan pricing. Nearly half claim to incorporate have begun to make progress in these areas, this remains slow, and
climate concerns into sector lending policies, suggesting that the all institutions were expected to take ‘decisive action’ to address
growing regulatory focus on climate issues is heightening scrutiny these shortcomings and better integrate climate risks into
of emissions-intensive activities in lending, and potential regulatory strategies, governance and risk management arrangements.
and market risks. A similar share of respondents report
incorporating climate considerations within client due-diligence
procedures and dedicated questionnaires. In their lending policies,
business model risks, many smaller banks still deem these risks
immaterial, and have not undertaken materiality assessments.
Integration of Climate Risks into Credit Risk Management
(%) Respondents: large eurozone banks Climate Risk Materiality
Yes No Physical risk as a material risk driver
Transition risk as a 3%
Sector lending policies
material risk driver
Client due dilligence 5%
Risk classification
Collateral valuations Both physical
Not material
Portfolio analysis or no and
assessment transitional
Loan pricing risks
done
41% 51%
0 20 40 60 80 100
Source: Fitch Ratings, ECB
Source: Fitch Ratings, ECB
This is consistent with the findings of Fitch’s survey of ESG
integration by global banks (ESG Bites into Banks’ Lending to In particular, although a majority of banks assessed regarded
Corporates). This highlighted widespread use of thematic and physical risks, together with transitional climate risks, as material
sectoral ESG risk screening by banks, albeit with limited consideration for their risk profile, most have significant knowledge
implications for risk pricing or lending decisions. gaps with regard to their physical risk exposures. Risk management
processes for physical risks were also seen to be underdeveloped.
The report highlights real estate as a sector where banks are
reviewing their collateral valuations with regard to transition risks, Very few institutions were seen to have explored the implications
by assessing the energy efficiency certifications of buildings as of wider environmental risks drivers, such as biodiversity loss and
tracking the certifications of properties as part of total collateral of pollution. The Bank of France is undertaking an assessment of
their portfolio. Fitch research (Energy-Efficient Mortgages in financial risks in the banking system from biodiversity and nature-
Europe – RMBS and Covered Bonds Perspective) has previously related risks, and several large European banks have heightened
highlighted a fragmented data and reporting landscape across the exposure to natural resources and nature-related industries in their
EU as a barrier to comparison of exposures between key markets. lending activities.
As mortgages represent about 44% of GDP according to estimates
by the European Commission, understanding exposures (both What Impact Could Emerging Global
physical and transitional) is crucial. The ECB noted that very few of
these institutions were considering the geographical location of
Disclosure Standards Have?
real estate assets, which is a precondition for understanding A commonly cited challenge for banks in assessing climate
exposure to physical risks, such as flooding. implications of their lending activities is the lack of standardised
and comparable disclosures from counterparties. The ECB has said
How Are Smaller Banks Managing These it expects regulated banks to assess their data needs to inform their
strategy-setting and risk management, to identify the gaps with
Risks? current data and to devise a plan to overcome these gaps and tackle
The ECB’s assessment of climate and environmental risk any insufficiencies. This will require substantial engagement with
integration by its regulated banks found several blind spots for counterparties to obtain comparable data.
banks in addition to risk management processes. While a majority In the EU, green asset ratio rules for banks taking effect this year
of larger banks (with assets of over EUR500 billion) recognised that should help improve comparability of disclosures around climate
climate and environmental risks will affect their risk profile over the risk, although detailed reporting will not be required until 2024. The
next three to five years, including financing, day-to-day and EU Corporate Sustainability Reporting Directive is intended to
Sustainable Insight │ 8 February 2022 sustainablefitch.com 4Sustainable Finance
Financial Institutions
EMEA
support this by extending the scope of disclosure requirements, but How Do You Expect Disclosure Under ISSB Standards to
will not come into force until January 2023, with companies starting Be Used in Bank Credit Analysis?
to report in line with the standards from 2024.
Only gradually, until regulatory
In the meantime, the onus will be on banks to supplement often requirements for banks become
inadequate corporate disclosures with their own data collection clearer
and analysis activities.
All sustainability-related factors will
A major development during COP26 was the announcement of the key drivers for the analysis
International Sustainability Standards Board under the aegis of the
IFRS Foundation. Intended to provide a common global baseline for Primarily only with respect to
climate risk exposure and it will
sustainability disclosures across a range of financial reporting require sufficient granularity
frameworks, the proposed standard also harmonises the work of
multiple sustainability reporting standard setters, such as the Value 0 20 40 60 80
Reporting Foundation (formerly Sustainability Accounting (% of respondents)
Standards Board), the Global Reporting Initiative, the Climate Source: Fitch Ratings
Disclosures Standards Board/CDP and the G20 Taskforce on
Climate Related Financial Disclosures. What Are the Implications of Financial
More than 40 central banks and finance ministries have welcomed Sector Climate Commitments at COP26?
the ISSB, and the dominance of IFRS within financial reporting
systems in 140 countries alongside the International Accounting While the Glasgow Financial Alliance for Net Zero (GFANZ)
Standards Board mean the recommendations of the new body are coalition’s announcement of reaching 450 members representing
likely to be rapidly adopted. USD130 trillion of assets under management drew significant
media attention at COP26, the impact of this coalition will be
Two outstanding uncertainties are the position of the US Securities determined by the stringency of reporting requirements – details of
and Exchange Commission, which does not align with IFRS which are set to follow in 2022.
standards and is undertaking its own consultation of climate risk
disclosures, and the EU, which has strongly embraced the principle Annualised disclosure of financed emissions is envisaged to be
of so-called double materiality (reporting of both financial and non- required of signatories, members will still have at least three years
financial ESG information) within its existing disclosure to detail transition plans (with a particular focus on transition
frameworks whereas the ISSB has adopted the principle of financial investments in the hard-to-abate steel, aviation, and oil and gas
materiality assessment espoused by the TCFD. While two sectors), and the formal disclosure framework will be finalised by an
prototype standards ‘General (ESG) Requirements’ and ‘Climate’ ‘expert’ committee in 2022.
for disclosures under ISSB will be finalised in 2022, existing drafts The fairly long timescale to comply with the GFANZ pledges means
are heavily aligned with the TCFD reporting framework, aiding that effective monitoring and accountability mechanisms will be
banks and financial institutions that have already invested key to the credibility of the coalition. In this respect, lessons can be
significant resources into reporting against the industry-led drawn from the UN Principles for Responsible Banking (PRB)
framework. initiative, which has been in place since 2019 but has seen wide
Nonetheless, reporting under TCFD remains voluntary and a variation in the breadth and quality of disclosures against the
fragmented patchwork of disclosures across companies and principles by signatories.
financial institutions limits the applicability of these disclosures in Members of both the GFANZ and the PRB have been criticised by
bank credit analysis. Moving the ISSB standards into the civil society for publicly advocating Paris Agreement alignment in
mainstream and adopting the TCFD within mandatory disclosure their investment strategies while increasing their exposure to
requirements should improve the usefulness of these disclosures fossil-fuel intensive activities, such as tar sands projects. The
within credit analysis. thematic/sector-specific focus of disclosures under GFANZ may
Fitch’s poll of webinar participants indicated that a significant strengthen the scrutiny of transition planning in these sectors, but
majority believed disclosures emerging from the ISSB standards it is unclear whether there will be consequences for signatories that
were only likely to be used in bank credit analysis gradually, as continue to expand lending, investment and underwriting activities
requirements for banks become clearer. that are detrimental to the goals of the Paris Agreement,
Banks have borne particular criticism for their membership of net
zero coalitions because of their more direct and active role in lending
and underwriting new fossil fuel infrastructure and projects. The
2021 Banking on Climate Chaos report found that the largest
commercial banks have increased their lending to fossil fuel projects
by USD3.8 trillion since the signing of the Paris Agreement in 2015.
European banks are generally in the vanguard on climate
integration within lending, but the CDP estimates that there is still
a gap of at least EUR4 trillion between the market for Paris-aligned
corporate bond loans and the overall size of corporate lending by
Sustainable Insight │ 8 February 2022 sustainablefitch.com 5Sustainable Finance
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EMEA
banks that publicly aspire to align their portfolio with the Paris Fitch expects this trend to intensify in 2022, with a growing focus
Agreement. Some 43% of European bank lending is not assessed for on exposure to emissions-intensive sectors in lending and
alignment with the Paris Agreement – and most is only partially investment as a result of climate stress tests.
assessed, according to the CDP.
While banks with high exposure to fossil fuel lending are likely to
Clearly, there remain large gaps in knowledge of bank lending come under even more intense pressure from activist investors,
activities and alignment with the Paris Agreement goals. While engagement with clients on low-carbon transition plans is likely to
initiatives like GFANZ acknowledge the need to engage with such take precedence over large-scale divestment or exclusion. Analysis
high-emitting sectors as oil and gas, timescales for alignment of by Bank Tracker has pointed to many European banks tightening
lending and underwriting practices do not appear to align with the lending policies to thermal coal projects in recent years, but placing
necessary trajectory for climate action under the Paris Agreement, far fewer limitations on oil and gas financing.
increasing the risk of a disorderly transition.
The Bank of Japan took a big step in December 2021 by extending
Research by University College London has pointed to USD7 more than USD18 billion of zero interest loans to promote lending
million-USD11 trillion of stranded assets over the next 15 years if by banks in support of low-carbon transition, the first major
the Paris Agreement is to be fully implemented, so risks to financial initiative of this type by a central bank.
stability from a disorderly transition are becoming an increasing
area of focus for financial system regulators.
Sustainable Insight │ 8 February 2022 sustainablefitch.com 6Sustainable Finance
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