Europe’s big banks should be able to cope with losses caused by extreme weather as well as with the insolvencies of companies that are badly hit by higher carbon emissions prices. In order for this to succeed, the ECB is now setting tight deadlines for them.
The ECB main building at sunset: According to the authority’s bank supervisors, the institutions pay too little attention to the consequences of climate change for their business models, strategies and risks.
The European Central Bank (ECB) has made climate change one of its core issues in recent years. In monetary policy, it wants to increasingly gear its monetary transactions to climate protection, and in banking supervision it integrates climate risks more closely into its analyses. On Wednesday, the ECB gave credit institutions now Deadlines set for better handling of climate risks and thus increases the pressure on the institutes.
Threats to banks and financial stability
Despite progress, banks must better identify and manage their climate and environmental risks, it said. According to the results of the most recent performance review, while 85 percent of institutions have implemented some basic practices, they lack sophisticated methodologies and granular information about the risks of climate change to their businesses. From the ECB’s perspective, climate and environmental changes pose both physical and transitory risks to banks and financial stability.
However, the banks continue to underestimate the extent of the climate risks considerably, and a wait-and-see attitude prevails among the institutes. For example, almost all banks (96 percent) still have blind spots when identifying risks. 107 macroeconomically important and 79 less important banks in the euro zone had to take part in the latest ECB analysis. This also included the Frankfurt-based so-called Europa Bank of the major Swiss bank UBS.
Supervisors expect banks to be able to cope with losses from extreme weather as well as any bankruptcies of companies affected by higher CO2-Emission prices or stricter legal framework conditions are strongly affected.
Threats of drought, floods and new products
But how exactly can climate change affect banks? For example, the productivity and profitability of certain industries could change as a result of climate change.
This applies, for example, to agriculture due to increased droughts, more frequent floods and the cultivation of other products, or to the construction industry due to more expensive insulation and more robust materials. In addition, a major flood could destroy many of the homes that have been pledged as security for real estate loans with a bank that has significant exposure to the region. According to the ECB, such changes can affect the lending standards of institutions.
The authority is now making a three-stage requirement for the banks. By March 2023 at the latest, the institutes must appropriately categorize their climate and environmental risks and carry out an analysis of the impact on their business. By the end of 2023, the ECB expects credit institutions to integrate climate and environmental risks into their corporate governance, strategy and risk management.
And by the end of 2024, the banks supervised by the ECB must meet all of the agency’s requirements and expectations, which it set out back in 2020, including full integration into the internal analysis of capital requirements and the stress test. Banks that do not comply with the requirements must expect penalties.
In 2020, the banking supervisors presented their expectations with regard to climate and environmental risks and drew up a roadmap. A year later, the ECB published an action plan, and in July of this year it finally presented the results of its first climate stress test as part of banking supervision. In doing so, she identified risks of at least 70 billion euros. In the eyes of the ECB, 65 percent of banks performed poorly, revealing deficiencies in their stress testing capabilities.
A large proportion of the institutions did not take possible climate risks into account in the internal assessment process for maintaining adequate equity. Less than 3 percent of the banks did very well.
Impact on capital requirements
Noisy ECB Executive Board member Frank Elderson is preparing the industry for the financial risks of climate change long-term project, which has only just begun. Measured against the expectations of the ECB, the glass is filling, but it is not even half full. Europe’s banks must therefore be prepared for the ECB to continue to tighten the screw in order to identify and prevent possible risks from climate change for banks and financial stability.
This is also reflected in the fact that the ECB has imposed binding qualitative requirements on more than 30 institutions in order to pass the annual review of their risks (SREP). For a small number of banks, the result of this year’s climate stress test is already having an impact on the points awarded in these risk assessments, it said. The points achieved in turn have an impact on the capital requirements of the so-called Pillar 2 for the bank.
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