Regulators Impose New Stress Tests Around Climate Change

Regulators are using ESG metrics tostress-test banks.

As wildfires rage, polar ice caps melt and the coronavirus pandemic wreaks havoc, financial regulators are looking to focus banks’ and insurers’ attention on the risks that climate change poses directly to their balance sheets.

The Bank of England and the Banque de France are spearheading the first comprehensive climate-change stress tests of banks and insurers. Tests for the UK’s largest institutions will be mandatory while participation by France’s largest banks, a number of which already consider climate risk in their risk-management framework, is voluntary. Both the UK and French stress tests will run 30-year climate-change scenarios based on data provided by the banks. Results from the French tests are expected next April while the Bank of England has postponed its tests until mid-2021 due to the pandemic.

French and UK regulators are not the first. Japan is conducting similar climate stress tests of its biggest banks and the European Banking Authority is considering including “climate-change sensitivities” in its EU-wide stress tests for the first time next year. But the US is lagging. While its largest banks are likely to embrace global norms, its regulatory framework is not keeping up with its counterparts in Western Europe and developed-market Asia, says Monsur Hussain, Senior Director for Financial Institutions, EMEA, at Fitch Ratings.

Stress tests should increase banks’ awareness of climate risk’s rising profile vis à vis credit, market, business, reputational and risk categories. Climate-change risk for banks and insurers can be either physical—rising sea levels, wildfires, hurricanes, floods—or else take the form of “transition risks” that arise as companies and countries shift to net zero-carbon emissions. 

While in essence these are just “regulatory learning exercises” at this stage, Janine Dow, a Senior Director with Fitch’s sustainable finance team, predicts the stress tests will eventually feed into new prudential capital requirements for European banks. “There will be capital costs assigned to these risks,” she says, “but at this stage, central banks are not trying to put an exact figure on how much.”