European banks are failing to assess climate risk properly in their loan books, according to the European Central Bank’s stress test.
In fact, only four in ten banks have a climate risk stress-testing framework. Most banks said they struggled to get accurate data to create frameworks. Even where frameworks exist, accurate strategic or location-based climate data is hard to collate. “Almost all banks mention the need for data to enhance their climate risk stress-testing framework,” ECB said.
Where frameworks exist, only 60 per cent of banks use the results they create to inform overall strategy. In addition, only 19 per cent use the framework to inform their loan strategies.
ECB also found 75 per cent of banks often fail to independently validate their frameworks. “Many banks with a climate risk stress-testing framework already in place do not currently involve the internal audit function in reviewing the framework (40 per cent),” it said.
Of the 40 per cent of banks with a framework, most (75 per cent) used it for operational risk stress testing or scenario analysis. “For reputational risk, less than 40 per cent of the banks indicate that climate-related and environmental events are included,” it said. Many banks do not consider reputation risk separately from business risk.
Most banks (80 per cent) showed mixed results in assessing climate risk in their counter-parties. The best assessed both the direct and potential indirect climate risk variables – but poor data and poor risk assessment models hampered their efforts.
“To conclude, banks’ efforts to incorporate climate risk into their credit risk modelling are still at a preliminary stage, which is due in part to the challenges banks are facing,” said ECB. “Banks will need to step up their efforts to ensure more climate-sensitive credit risk modelling in their stress-testing frameworks.”