The role of climate stress test exercises in bank supervision is becoming increasingly prominent. Regulatory authorities have been conducting supervisory climate stress tests to evaluate the potential impact of climate-related risks on the stability and resilience of banks and other financial institutions (FIs). Currently, the tests serve as learning exercises. The outcomes are preliminary and come with certain restrictions, including incomplete data, and limitations in the modelling process (scenarios and designs). Additionally, various regulatory bodies may utilize distinct methodologies and frameworks when conducting these exercises, creating challenges in comparing and harmonizing the findings across different jurisdictions and regulatory frameworks.
While many central banks have climate scenario exercises underway, a majority of them are still in the pilot phase, with very few having concluded and reported on the tests.
The findings of completed climate stress testing exercises can offer valuable insights for other central banks and supervisors (CB&S), where they may learn from the methodologies used and tailor their own stress testing frameworks.
Key challenges and lessons
The 2021/2022 Climate Biennial Exploratory Scenario (CBES) stress test in the UK provides important insights for future climate scenario analysis. The CBES revealed many data gaps pertaining to areas such as counterparty emissions, transition and adaptation plans, supply chain information, and geolocated asset data. Similarly, the European Central Banks’ 2022 climate stress test highlighted the widespread reliance of banks on proxy data to gather essential information regarding scope 1, 2, and 3 emissions.
The CBES also emphasized the difficulties in interpreting the findings of the exercise to facilitate decision-making. The exercise design required making trade-offs, such as adopting a static balance sheet assumption and determining the scope of included risks. This could potentially lead to overestimation of certain risks due to the static balance sheet assumption and underestimation of risks in other areas due to the omission of relevant risk transmission channels and factors. As a result, decision-makers need to be aware of these limitations and consider them when utilizing the findings for making informed decisions in managing climate-related financial risks.
The way forward
CB&S, the government, and FIs need to prioritize addressing data gaps continuously to make the analyses of exercises more useful. One way to tackle the lack of counterparty data is by implementing disclosure requirements, a responsibility that falls on CB&S and the government. Focusing on obtaining future climate transition plans is also crucial as it remains a significant data gap that needs attention. Investing in data aggregation platforms can enhance risk assessment and efficiency for CB&Ss, the government, and FIs. Moreover, supporting the development of open Geoasset data as a public good, involving CB&S, relevant third-party institutions (RTIs), and the government would be key in enhancing data access and quality.
To improve the quality and pertinence of future exercises, CB&S may also form a multidisciplinary scientific and technical advisory group, via forums such as the Network for Greening the Financial System (NGFS). This group needs to comprise of experts from FIs and RTIs who can offer valuable perspectives, insights, and conduct an open peer review of existing scenarios and methodologies.
In order to strengthen climate stress testing, converting company disclosures into more comprehensive data that can be utilized for the financial impacts is also meaningful. This entails understanding and incorporating the complete range of potential supply chain effects. Additionally, it is crucial to comprehend and model the transmission channels through which risks can develop and impact a firm’s balance sheet. Properly combining data, models, and scenarios is essential, striking the right balance between analytics and qualitative approaches to scenario analysis. Moreover, a deeper understanding is needed regarding the relationship and sensitivity of stress test results to different variables. It is also important to convert climate pathways into economic scenarios spanning multiple years. Short-term scenarios, such as those utilized in the European Central Bank stress test, can serve as a foundation for further development.
With the Fed’s Pilot Scenario Analysis underway next, there would be value in understanding the specific challenges they encounter during the process.
The implementation of climate stress tests for financial institutions is still in its early stages. As financial regulators increasingly require these exercises, they have the potential to empower stakeholders with valuable information. While regional variations are likely to continue, the adoption of such practices can contribute to the availability of more climate-related information and generate more insightful results for investors.