‘Vast majority’ of banks taking ‘uninformed decisions’ on climate risk, warns ECB, as study highlights disregard for topic in capital buffers

‘Banks are encouraged to quickly adopt a forward-looking, comprehensive and strategic approach to managing these risks,’ says EU supervisor

Close to a third of surveyed European banks have not considered whether their capital is vulnerable to financial losses resulting from climate change.

A new report from the European Central Bank (ECB) shows that most regulated banks do not consider climate-related risks when setting aside additional capital as insulation, or a ‘buffer’, against heavy losses in times of economic fallout.

Ensuring that banks have adequate capital buffers is key to the financial sector’s resilience and is a top supervisory priority for the ECB, which described its findings as “rather concerning”.

According to the ECB, 26 of 37 banks surveyed considered climate change in their risk identification process, with just under one-third of those banks concluding that such risks were material. A total of 11 banks did not consider climate-related risks at all. The identities of the banks were not disclosed.

The ECB itself considers climate change “a key risk driver for the euro area banking sector”.

In an accompanying analysis, the supervisor observed that climate-related risks were often bundled together with other risk categories, with “environmental and social risk” and “sustainability risk” being the most common buckets. In addition, internal practices for considering climate change within risk management processes significantly diverged among banks and relied mostly on qualitative assessments.

In its conclusion, the ECB said: “The vast majority of banks have not yet established internal processes that allow them to systematically identify and manage climate-related risks. Therefore, these banks continue to take uninformed business decisions that expose them to risks that could have material negative consequences for capital adequacy in the medium to long term”.

“Banks are encouraged to quickly adopt a forward-looking, comprehensive and strategic approach to managing these risks.”

The 37 banks surveyed were chosen as a representative sample for European banks, “with a stronger focus on larger banks”, and included all bank clusters and “almost all business models”.

The ECB last updated its supervisory expectations on banking capital buffers in late-2018 but did not make any explicit reference to climate change or sustainability risks at the time.

An alternative supervisory approach is to consider environmentally-friendly assets less risky and carbon-intensive assets more risky when determining adequate capital buffers for banks. This approach, which has been championed by the European Commission’s Valdis Dombrovskis, Bank of France Governor de Galhau and the European Banking Federation, has nevertheless remained on the fringes of mainstream central banking over concerns it would increase the risk of insolvency.

The European Banking Authority (EBA) is now examining whether such a policy would be justified as part of its workplan on sustainable finance. The EBA is also drafting technical standards governing the disclosures of ESG, physical and transition risks to capital by major banks, and considering the potential inclusion of ESG risks within supervisory assessments.