UK banks face stress test on climate change

On Tuesday the Bank of England announced it would run an extensive stress test to explore the financial risks posed by climate change for the largest UK banks and insurers.

The bank runs regular exploratory scenarios to help assess the resilience of the UK financial system and individual institutions.

The Climate Biennial Exploratory Scenario (CBES) test explored the risks arising from the significant structural changes to the economy needed to achieve net zero emissions, which the bank describes as ‘transitional risk.’

The 2021 exercise also addressed the risks associated with higher global temperatures, or the ‘physical risks.’

The CBES used three scenarios of early, late, and no additional action to explore the two key risks. These scenarios are built on a subset of the Network for Greening the Financial System scenarios, which are applied over a span of 30 years, which the bank said reflects the longer-term nature of climate-related risks.

Other features of the stress test include sizing the risks banks and insurance face based on their current (fixed) balance sheets. For banks, the exercise focused on their credit books, whilst for insurers, the exercise assessed risks to both their assets and liabilities.

The stress test also included a qualitative questionnaire to capture bank and insurer views on their risks, their approach to climate risk management, and their potential management actions.

Firms were obliged to conduct a detailed, bottom-up ‘counterparty-level analysis’ on their largest counterparties, involving using novel modelling approaches.

For the remainder counterparties, financial institutions were expected to differentiate exposures by geography and sector.

“Today’s exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole,” Andrew Bailey, governor of the Bank of England, said on Tuesday. “It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks."

Bailey added: “It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”

Sarah Breeden, the Bank of England executive sponsor for climate change said: “We are excited to launch today’s climate scenarios, which build upon the second iteration of NGFS scenarios released yesterday. They provide central banks and supervisors around the globe with a common starting point for analysing climate risks under different future pathways."

Breeden added: “Though fiendishly complicated, climate scenario analysis is a critical part of our toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system. Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action. By highlighting the risks of tomorrow, they can help guide actions today. I encourage all firms, not just those participating, to engage in and learn from this exercise.”

The Bank expects to publish the CBES results in May 2022.

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