European banks will soon be required to incorporate climate change risks into the stress testing of their equity.
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Researchers at the Technical University of Munich (TUM) have now developed a new approach in cooperation with the Frankfurt Institute for Risk Management and Regulation (FIRM).
In a case study they applied their stress testing method in several CO2 pricing scenarios.
Due to sharp rises in probabilities of credit default in several industries, the results show that the bank in question would face significant decreases in capital ratios. The model can help banks to prepare for future risks.
Climate change can cause substantial losses to companies, not only as a direct result of extreme weather events, but also through transitory risks, above all in the form of rising CO2 prices and long term decreases in economic value creation.
This, in turn, means greater risks for banks if companies are unable to service loans. Consequently, the European Central Bank (ECB) and the European Banking Authority (EBA) have ordered financial institutions to incorporate climate risks into their risk management and stress testing processes, which serve primarily to evaluate their capital buffers. The new requirement will take effect in 2022.
It is still unclear, however, how this requirement can be implemented.
Nor is it certain what dimensions the transitory climate risks might reach in stress tests.
Researchers at the Technical University of Munich (TUM) have therefore worked with the Frankfurt Institute for Risk Management and Regulation (FIRM) to develop a method that can be adapted to a variety of stress tests and have applied it in two case studies involving a bank and two investment funds.
The stress test shows that across all scenarios, the bank's common equity Tier 1 (CET1) capital would decrease by between 0.1 and 1.2 percentage points.
The core capital ratio (Tier 1) would be down by 0.1–1.3 percentage points and the total capital ratio by 0.2–1.6 percentage points. By comparison: the average core capital ratio of European banks was 15 percent at the end of 2020, so that the scenarios analyzed by the researchers would mean decreases of between 1 percent and nearly 10 percent. ■