European banks have barely finished their discussions on the EU-wide stress test results with the supervisor, but they already have an eye on next year’s ECB climate risk stress test. The 2022’s exercise will bring new challenges to banks, especially regarding their stress test data capabilities.

The timeline of the upcoming supervisory stress test on climate risk will resemble that of the previous year, with the kick-off in March 2022 and results expected to be published in July 2022. The output of the exercise will be used to inform the Supervisory Review and Evaluation Process (SREP) through a qualitative approach.

Climate stress testing, yet again on the agenda of supervisors

The last few years have seen climate change receive increasing attention from policymakers, supervisors, and other relevant institutions, many of which have conducted stress test-like exercises of European banks. A few examples are the energy-transition stress tests conducted in 2018 by the central bank of the Netherlands (DNB), the joint climate pilot stress-test exercise coordinated by Autorité de contrôle prudentiel et de resolution (ACPR) and the Banque de France in 2020, or the Climate Biennial Exploratory Scenario (CBES) launched by the Bank of England in June 2021.

It is well known that climate-related and environmental risks have also been high on the ECB’s agenda for several years and it is highly likely to become one of the SSM priorities for the year ahead. This does not come as a surprise, as the financial sector plays a crucial role in driving the transition to a sustainable economy, as highlighted in KPMG’s recent SSM beyond COVID-19 publication. As part of its climate roadmap, the ECB already conducted an economy-wide climate stress test in 2021. The results and methodology of this process will be used to inform the ECB’s supervisory bottom-up stress test on climate risk and the climate stress test of the Eurosystem balance sheet. Both are planned for the first quarter of 2022.

Significant challenges posed by the supervisory climate stress test

The 2022 ECB climate risk stress test will serve several purposes, but the primary goal is to assess European banks’ climate risk stress test capabilities - and their vulnerabilities to transition and physical risks - under certain assumptions and a range of climate scenarios.

The upcoming supervisory climate stress test will be the first of its type for most European banks directly supervised by the ECB. This implies that banks will face several significant challenges as they carry out their preparatory work, including:

  • Internal organisation and structure. Discussions with banks lead us to believe that many expect to integrate the exercise into a broader internal stress test programme. Others plan to conduct the exercise as a separate regulatory stress test, or to follow a combination of both approaches.
  • Accountability. For specific parts of the exercise, banks will be required to report financial data - in line with financial reporting (FINREP) - and other non-risk-related data (e.g., GHG emissions) in addition to credit, market, or other risk data. This could encourage banks to appoint more than one owner of the exercise. In this sense, we expect most banks to conduct the exercise under the responsibility of both the CFO and the CRO.
  • Credit risk. Although the ECB tries to keep methods simple, credit risk projections involve significant challenges concerning methods, data, and processes. Specific challenges include limited data availability and dependencies with other climate-related topics such as risk classification procedures and definition of sector (decarbonization) strategies still under development. The translation of carbon price scenarios into credit risk parameters and the projection of the balance sheet for the upcoming stress test thus rests on an insufficient basis of methods and results from activities from the overall ESG projects of the banks. Lastly, the lack of experience and data for back-testing and plausibility analyses offer little room for sanity checks of the stress test results.
  • Operational risk. Most banks have been storing information on internal operational risk events in their systems for many years. However, they will need to make additional efforts to go through their databases to identify those events derived from climate or environmental issues related to conduct and physical risks for the last five years.
  • Data templates. Based on the experience of previous stress tests, the introduction of new templates will require banks to adjust their IT processes and infrastructure to provide extensive high-quality starting point data.
  • Data capabilities. Part of the data that will be requested (e.g., GHG emissions for specific counterparties or Energy Performance Certificates) may not lie within the scope of the data stored by banks in their internal systems. Banks will therefore have to rely on external providers to fill their data gaps as far as possible.

What’s next?

The upcoming ECB climate risk stress test is approaching fast. Until now, one of the main concerns for banks was whether they must provide projections. However, the ECB recently informed individual banks if they will be required to provide projections for credit and market risk, in addition to the starting point values for these two types of risks. Smaller banks will not be required to compute their projections and will be subject to a less complex quality assurance process.
On the other hand, some parts of the exercise have not been yet confirmed, but banks continue to progress their preparatory work and will eventually conduct internal stress test exercises, which could help them assess their methodologies, data, and processes.

Looking ahead, some of the key milestones before the start of the exercise are as follows:

  • The workshop that the ECB will host with banks included in the scope of the exercise around December 2021.
  • Although the ECB released an updated version in October 2021, the final versions of both the methodology and data templates will be published shortly before the start of the exercise in 2022, just like the scenarios.

European banks may still be waiting for the confirmation of some elements of 2022’s climate risk stress test, but we expect most to continue focusing their efforts on preparation. This will allow banks to ensure their readiness for the data collection phase and guarantee a smooth quality assurance process.

                

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