A climate risk stress test that the European Central Bank (ECB) conducted with more than 100 banks showed that most banks lack a climate risk stress-testing framework and do not include climate risk in their credit risk models, thus posing a risk to financial stability in Europe.

Moreover, around two-thirds of banks’ income from non-financial corporate customers were found to stem from greenhouse gas-intensive industries.

“Euro area banks must urgently step up efforts to measure and manage climate risk,” said Andrea Enria, chair of the ECB’s Supervisory Board.

Neglected climate risks

Of the 104 banks that participated in the stress test, 60% were found not to have a climate risk stress-testing framework, and only 20% consider climate risk as a variable when granting loans.

If banks do not adequately include climate risks in their models, this exposes them to unexpected losses, for example, if an oil company they funded goes out of business due to climate change policies. If this happens at scale, the financial system’s stability is at risk.

“The stress test is an important learning exercise for the banking sector,” said Wim Mijs, CEO of the European Banking Federation, in a press statement.

A spokesperson of the ECB confirmed to EURACTIV that the climate stress test had “a very strong learning component” since climate stress tests are still a relatively new instrument for the banking industry.

However, climate change is not known to be a very patient phenomenon. “Banks are still very far from our expectations,” the ECB spokesperson said.

Not enough data

Data availability appears to be a particular problem, as banks are often unaware of their clients’ climate risks. Caroline Liesegang, head of prudential regulation and research at the Association for Financial Markets in Europe, said that “climate risk analytics and climate risk data is still in its infancy.”

“There is still much work to do to close data gaps, refine scope and scenarios and, of course, understand the mechanics of transmission channels into banks’ balance sheets and portfolios,” she added.

The stress test showed that, in many cases, banks’ “financed emissions” come from a small number of large companies, which increases their exposure to transition risks, according to the ECB.

According to the Green member of Parliament Rasmus Andresen, the climate risk stress tests “clearly show that banks do not take climate risks seriously enough.”

“The disappointing results also show that ambitious and rigorously enforced legal guidelines are urgently necessary since banks do not seem to sufficiently follow voluntary recommendations,” he said in a press statement.

Higher capital requirements?

While the European Banking Federation agrees that “more should be done to incorporate climate risk into the stress-testing frameworks and internal models,” its CEO Wim Mijs said that banks could only play a “major role” in Europe’s green transformation “if supported by governments’ industrial and climate policies.

Earlier this year, a member of the ECB Supervisory Board, Édouard Fernandez-Bollo, explained that the climate stress test was only a first step in a long process.

“This stress test isn’t the end of the story – eventually, we will have capital requirements,” he said in an interview with Revue Banque. Thus, banks might one day have to secure their climate change exposures with more capital, making these exposures more costly for the banks.

While this is not a settled policy, there are plans for the medium term. The ECB will publish more specific climate risk guidelines and best practices for banks later this year; a spokesperson told EURACTIV.