Why banking regulators are sweating under climate stress tests – Business Daily
The Central bank of Kenya, Nairobi on Wednesday, December 30, 2020. PHOTO | DENNIS ONSONGO | NMG
The Central Bank of Kenya (CBK) says that climate-related financial risks can significantly increase bank credit risks as a result of severe floods, drought, landslides and wildfires that destroy borrowers’ assets or impair supply chains.
With a high reliance on physical collateral in lending in emerging markets, measures put in place to mitigate climate change can also increase credit risks from collateral assets that become stranded.
“Extreme weather events can also increase the operational risk for banks due to disrupted business continuity from negatively impacted bank’s infrastructure, systems, process and staff,” the CBK says in its guidance on climate-related risk management.
The CBK has asked lenders to put in place governance, oversight and risk management strategies to prepare the industry to face the growing climate-related risks.
As a start, the regulator and banking industry players came up with some steps that evidence their recognition of the potential impact of climate risks.
Though some of these initiatives started as far back as 2013, their adoption and impact are still a work in progress as most lenders prefer to look at the risks through a corporate social responsibility lens, which has seen compliance remain a moving target.
Kenyan banks are not the only ones struggling. Globally, sector regulators are still struggling with climate stress tests at a time when the world is experiencing its worst climate-related calamities.
The first stress tests to assess banks’ exposure to risks of climate change are underestimating the worst-case scenario, the European Central Bank and Bank of England have said, underscoring the challenge of making such exercises more useful.
The banking regulators say the tests are needed to assess vulnerabilities in the financial system from climate change-driven catastrophes, be they in the banks’ loan portfolios, trading books or customer accounts.
Here is why regulators, investors and banking experts say climate stress tests are still a work in progress but improvements are on the way:
For a bank to understand the climate risks embedded in their financing, they need access to accurate data from clients, including their current emissions and the plan to reduce them over time.
While regulators in the European Union and elsewhere are starting to push companies in the real economy to provide this data, it remains early days and banks have had to rely on estimations. The approaches taken by banks to fill in the gaps in data also vary.
Tougher, mandatory climate disclosure rules for companies in the European Union, Britain, and the United States from 2024 onwards will plug gaps in emissions data from customers of banks, giving a far more accurate picture of exposures.
“The disclosure tool will be a bit of a game changer,” said Monsur Hussain, senior director at credit ratings agency Fitch, meaning climate tests will “get more stressful” for banks.
The lending decisions made by banks over time determine the risk on their balance sheet, yet modelling this is hard. A static balance sheet, which assumes no change over time, is unrealistic, yet a dynamic balance sheet requires many assumptions to be made, which could be equally wrong.
Regulators say they expect the modelling to improve over time, while the process will help lenders and policymakers develop the mindset, knowledge and skills needed to come up with better tests for making decisions in future.
“Asking them to do that preparation and asking whether they are or aren’t prepared, is a really important question,” said David Carlin, climate risk programme lead for the Unep Finance Initiative, a joint UN and finance industry undertaking.
While the initial stress tests have taken into account macro-economic and financial variables, for example the imposition of a higher carbon price through government policymaking, they do not capture all of the potential risks associated with climate change, such as climate-related litigation, and, equally as important, how these differing risks will interact with one another.
Traditional financial stress tests, introduced after the financial crisis of 2008-2009, typically focus on resilience to shorter-term shocks to a bank’s solvency, and are more closely aligned to a lender’s planning horizon of two-five years.
Climate stress tests, on the other hand, tend to focus on risks that may play out over decades into the future with data covering such lengthy periods patchy at best.