Stress-Testing

As governments and regulators ‘race to the top’ with steeper climate targets and stronger policy actions, questions remain about the resilience of the financial sector to climate change and whether it is doing enough to support the transition to a low-carbon economy. The upcoming climate stress tests may provide some, if not all, of the answers. By Alex Frankl, managing director at Accenture’s UK risk practice.

As was demonstrated in the years following the 2007-9 global financial crisis (GFC), stress tests, alongside other regulatory measures, can be a powerful tool, both for catalysing capital transformation and for encouraging investment in data and analytics capabilities. 

The present moment is no different. The Bank of England’s Climate Biennial Exploratory Scenario (CBES) – the world’s first climate stress test, to be launched in June 2021 – represents a significant step towards ‘greening’ the regulatory agenda in financial services. It should provide further insights into the vulnerability of the financial sector to climate change-related risk, and act as a bellwether of prudential changes to come.

Rising to the challenge of conducting these stress tests is no mean feat. But more importantly, financial institutions should take their cue from the Bank of England’s resulting communications to grasp where regulators stand on policy choices to incentivise and prioritise climate transition. 

Stress tests themselves

For the upcoming CBES exercise, the UK’s largest banks and insurers will be asked to analyse the impact of three different climate scenarios on their business model and balance sheet strength over a 30-year projection window. Those scenarios represent different levels and policy interventions and therefore also different levels of physical climate change. 

While the CBES shares several core features with annual stress tests, the nature of the scenarios and the extended time horizon means that the analytical architecture used for macro-economic stress testing will require significant enhancement. 

While the industry has invested significantly in CBES capabilities, the industry is still relatively immature when it comes to modelling the financial implication of climate change, not least because understanding the sensitivity of their portfolios to physical and transition risk requires access to new categories of data (asset-level data, geolocation, carbon intensity, supply chains and so on) for which solutions are only just coming on-stream. 

First of many 

When considering how the practice of climate stress testing might evolve, the path macro-economic stress testing took in the years following the GFC provides a useful guide. There, regulators’ expectations around data granularity, internal governance and modelling standards were increased cycle after cycle, forcing banks to continue investing in their data and analytical infrastructure for almost a decade. 

We expect a similar pattern with climate stress testing. Regulators are likely to continue raising the bar around the robustness and granularity of the analysis as a means to force the banks to invest in data and modelling and to continue engaging their boards on the key strategic questions around the reliance of their business model on carbon-intensive industries and their ability to understand customer resilience to physical climate change.

Part of a package

Comparing the challenge of greening the financial system with the previous decade’s challenge of recapitalising and repairing the financial system, we can also see how stress testing might fit into a multi-faceted regulatory strategy. In the post-GFC case, macro-economic and market stress testing was paired with more direct and prescriptive regulations around data quality (such as BCBS-239) structural reform (such as recovery and resolution plans) and prudential standards (such as various changes to capital and liquidity regimes). 

Fast-forward to the current challenge and we might see a similar dynamic. Disclosure regimes such as the Task Force on Climate-Related Disclosures and the EU Taxonomy and new Green Asset Ratio help clarify expectations around data and disclosure. Climate stress testing provides the second pillar. This leaves the big question of whether regulators will use the prudential lever to incentivise the reallocation of capital, via a green factor. 

Indeed, the Basel Committee is undertaking further work across regulatory, supervisory and disclosure for the banking system, alongside closing gaps in the Basel Framework to address climate-related financial risks, potentially paving the way for a ‘green-tinted’ Basel IV.

So, as the Bank of England publishes the CBES results later this year, there are a number of things to look out for. Not just for the narrative around banks’ resilience to climate change but also the commentary on how far the industry still needs to travel before reaching an acceptable level of maturity regarding climate risk quantification. Not to mention how far the Bank of England itself plans to travel towards a more favourable capital treatment for green assets.

The regulatory spotlight is only going to intensify on climate risk. The financial sector will need to demonstrate its readiness through continued investment in new data solutions, more sophisticated climate risk analytics and the embedding of climate risk considerations into their risk management framework and business-as-usual decision making.