Climate stress tests: Are banks fit for the green transition?

Climate stress tests have emerged as a key tool for looking into the financial system’s vulnerability to climate risks. Banks’ exposure to climate risks stems from (1) physical risks that are closely related to geography, and (2) transition risks mainly from loans to carbon-intensive sectors. Exercises by the ECB and BoE suggest that banks’ credit losses in a disorderly transition would be higher than in an orderly transition scenario, and even higher in a “hot house world” with unabated global warming. Banks would be able to absorb climate-related losses due to strong capital buffers. Results are subject to data limitations and modelling constraints. So far, climate stress tests are declared learning exercises with no direct implications for capital requirements. However, supervisors are urging banks to set up a comprehensive climate risk management. [more]