EU climate stress test ‘significantly understates’ banking losses, says ECB

The EU supervisor has flagged the reliance of European banks on income from carbon-intensive sectors.

EU banks would have faced credit and market losses upward of €70 billion over three years if severe drought and heatwave hit the continent in January 2022.

The hypothetical scenario is among a handful considered by the European Central Bank under its first major climate stress testing exercise, which was published today.

However, the figures are “significantly understated… as it reflects only a fraction of the actual hazard” due to data and modelling limitations and the small scope of the analysis, the ECB warned. The figure accounts for around one-third of the total exposures of 41 large EU banks and was based on calculations proposed by banks themselves without any supervisory modifications.

In addition, the modelling does not consider an economic downturn that would be caused by the climate hazards, nor does it capture second-order consequences, such as losses borne by insurance companies.

Under long-term climate scenarios spanning 30 years, banks would experience lower losses if climate policies are introduced early and gradually become more stringent, compared with scenarios where climate policies are delayed or not implemented at all. This is in line with long-established expectations that have shaped policymaking and financial supervision.

But the ECB noted that banks do not yet have differentiated strategies that reflect the various transition paths, apart from a general “tendency” to reduce exposure to carbon-intensive industries and support lower-carbon alternatives.

“These results are not ground-breaking but still quite useful, although we should be very careful about the size of the climate-related financial impacts which are presented here,” said Paul Schreiber, the supervisory lead at climate think tank Reclaim Finance. “I think it makes a strong case for a discriminatory approach which targets high-emitting sectors and companies.”

Schreiber also pointed out that the exercise did not integrate double materiality considerations, despite the concept being adopted by EU policymakers under the bloc’s sustainable finance programme and the recent incorporation of climate considerations in the ECB’s monetary policy operations.

The ECB stress test surveyed a broader group of 104 significant EU banks and found that 60 percent do not yet have a climate risk stress testing framework, and only 20 percent consider climate risk when granting loans. Among those with stress testing frameworks in place, just 24 percent factored in liability and reputational risks in contravention of best practices, as outlined by central banking body the Network for Greening the Financial System.

It also found that more than 60 percent of bank income from non-financial clients was provided by carbon-intensive sectors and concentrated among a small number of major companies.

“Banks have taken this as a learning exercise where a lot of progress has been made in areas where there was no information just a year ago,” said Gonzalo Gasos, banking supervision head at EU banking trade body the European Banking Federation. “Banks have made hundreds of thousands of information requests to their clients but of course you can’t do everything in one year. This is the first step in the right direction.”

The ECB has also stressed that the stress test is a “learning exercise” and will not have any direct impact on banks’ minimum capital requirements. However, it will factor into the ECB’s overall supervisory review assessment process, which will also include thematic reviews of bank climate policies and on-site inspections.

The ECB is set to publish bank-specific recommendations and guidance to help banks build their internal climate risk stress-testing frameworks in Q4.