ECB finds that banks must sharpen their focus on climate risk

The European Central Bank (ECB) has published the results of its 2022 climate risk stress test, which show that banks are not yet sufficiently incorporating climate risk into their stress-testing frameworks and internal models, despite some progress made since 2020. 104 banks participated in the test consisting of three modules, in which banks provided information on their:

(i) own climate stress-testing capabilities;

(ii) reliance on carbon-emitting sectors; and

(iii) performance under different scenarios over several time horizons.

The ECB’s findings show that:

  • around 60% of banks do not yet have a climate risk stress-testing framework and most banks do not include climate risk in their credit risk models, and just 20% consider climate risk as a variable when granting loans;
  • almost two-thirds of banks’ income from non-financial corporate customers stems from greenhouse gas-intensive industries. In many cases, banks’ “financed emissions” come from a small number of large counterparties, which increases their exposure to transition risks. Banks often rely on proxies to estimate their exposure to emission-intensive sectors; and
  • banks’ vulnerability to a drought and heat scenario is highly dependent on sectoral activities and the geographical location of their exposures. The impact of this risk materialises through a decrease in sectoral productivity, e.g. in agriculture and construction activities, and an increase in loan losses in the affected areas.

All participating banks received individual feedback and are expected to take action accordingly, in line with the set of best practices that the ECB will publish in Q4 2022.

Harshil Patel