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Bank of England climate stress test targets financial sector

Author: ICAEW Insights

Published: 17 Jun 2021

New stress tests to reveal the level of exposure and resilience of the UK’s largest financial institutions to climate change have been announced by the Bank of England, as it looks to beef up the sector’s ‘relatively immature’ experience and expertise in modelling climate-related risks.

The stress tests will put 19 banks and insurers through three climate scenarios, from early action to one in which governments fail to take further steps to curb greenhouse gas emissions, resulting in average temperature increases of 3.3C and a 0.39-metre rise in sea levels. The central bank will be monitoring the physical and transition risks of those scenarios, including how they could affect potential loan losses as customers default due to slowing growth and economic uncertainty.

The BoE says testing both banks and insurers using the same scenarios will allow it to size the risks presented by climate change across the financial system as a whole. The exercise will also explore how firms intend to adapt their business models over time and the management actions participants anticipate taking in the published scenarios, as well as participants’ present and future planned approaches to managing climate risk. 

Bank of England Governor Andrew Bailey said firms would have to engage closely with their counterparties in order to source detailed data on those counterparties’ exposures to these risks. “It will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate-related financial risks across the sector.”

The climate scenarios build upon six scenarios released last week by the Network for Greening the Financial System (NGFS), a network of 83 central banks and financial supervisors that aims to accelerate the scaling up of green finance and develop recommendations for central banks' role for climate change.

Sarah Breeden, the Bank of England Executive Sponsor for climate change, said: “Though fiendishly complicated, climate scenario analysis is a critical part of our toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system. 

“Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action. By highlighting the risks of tomorrow, they can help guide actions today. I encourage all firms, not just those participating, to engage in and learn from this exercise.”

However, the exercise will not be used by the Bank to set capital requirements, and individual participants’ projected losses will not be tied directly to actions participants are required to take. 

Zsuzsanna Schiff, Manager, Auditing and Reporting in ICAEW’s Financial Services faculty, described the announcement as an essential step in the right direction but. Schiff added that only the first step; we need a much more robust set of data before the stress test could be used to set capital requirements. 

“Large financial services organisations are generally more advanced than most other corporates at assessing their climate change risk exposures but they need information from their clients and customers to do this. The success of this stress test will ride on the information banks and insurers receive. To have continued access to financial services corporates will carefully think about what information they are able and willing to share.