Banks in the eurozone will need to develop strategies to account for climate change risks

ARTICLE WRITTEN FOR TRF NEWS, JULY 2022

It is increasingly clear that financial institutions need to urgently augment their efforts to measure and manage climate risks
Author: Luiza Buserska, Corporate Communications Executive at CODIX

Europe has been gripped by an unusual drought in recent months, with record high temperatures in many places, putting many countries' energy systems to the test. Experts cannot estimate how this will affect the preparations of the EU countries for the winter, which are under the sign of reduced supplies of natural gas from Russia.

Against this background, however, most banks in the Eurozone do not include climate change risks in their internal models and stress testing frameworks. These are the results of the first study of the European Central Bank (ECB) on the subject.

Banks have already tightened their lending standards for loans to businesses and households amid growing uncertainty, jumping inflation and the gas crisis. At the same time, the demand for corporate loans has continued to grow, driven mainly by working capital financing needs.

This conservatism trend will intensify in the next quarter as banks' tolerance for risk-taking is decreasing. Amid the deepening conflict in Ukraine, which has soured sentiment and pushed the EU closer to recession, banks are becoming increasingly fastidious in approving loans, which could further fuel the economic downturn. That will also amplify banks‘ offering of receivables finance/SCF/factoring, due to tighter control on the exposure and flexibility for their clients. Similar to the period 2008-2010, we can expect again that, as a consequence of the tightening of bank lending, the demand for alternative and powerful instruments such as factoring will augment.

At the same time “euro area banks must urgently step up efforts to measure and manage climate risk, closing the current data gaps and adopting good practices that are already present in the sector,” said Andrea Enria, Chair of the ECB’s Supervisory Board.

A total of 104 banks took part in the ECB's first-ever stress test, providing information across three categories, including performance under different scenarios, exposure to carbon dioxide-emitting sectors and their own climate-related stress testing capabilities.

On the latter criterion, nearly 60% of banks still do not have the necessary test framework in place, with most participants not including climate in their credit risk models and only 20% considering climate risks as a variable in loan approvals.

At the same time, 41 banks are placed under direct supervision to ensure proportionality with smaller financial institutions in pursuance of Principle 7 of the Single Supervisory Mechanism. The application of this Principle facilitates the efficient allocation of limited supervisory resources. Accordingly, the intensity of supervision varies across credit institutions, with a stronger focus on the largest and more complex banking groups. The larger the institution, the stricter the control over it.

The data also indicate that credit and market losses may reach around 70 billion euros on average this year for the 41 banks in question. The climate risk stress test performed by the ECB requires banks to project losses in extreme weather events and under transition scenarios with different time horizons. Findings show that banks’ vulnerability to a drought and heat scenario is highly dependent on sectoral activities and on the geographical location of their exposures. The impact of this risk materializes through a decrease in sectoral productivity (e.g.: in agriculture and construction activities), and an increase in loan losses in the affected areas. Similarly, in the flood risk scenario, real estate collateral and underlying mortgages and corporate loans are expected to suffer, particularly in the most affected locations.

The reason for the anticipated losses is that many banks do not appear to have clearly defined long-term strategies for credit allocation policies which reflect the various transition paths. Banks should strengthen their long-term strategic planning, e.g. green transition plans and goals. To do so, they will need to find credit risk management mechanisms that cover all existing requirements.

Most banks will need to work further on improving their governance structure for stress testing frameworks, their data availability and their techniques for building robust models. Regulatory requirements are intensifying and financial institutions will need to adapt to these changes. Fortunately, modern technology can be very helpful in this regard and greatly facilitate this inevitable process of transition to a green economy. Digitization is mandatory and its internal implementation by building own resources or with strong external suppliers can help banks achieve it.

The question is: “To what extent are banks open to such a transformation and how will they ensure their compliance with all regulations and the good management of climate and environmental risks in the financial sphere, in line with the European Green Deal”. It is increasingly imperative that financial organizations make strategic decisions about their modernization which will help them adapt to the constantly changing environment.

This article was published by BCR, the leading provider of news, market intelligence and training for the global Receivables Finance industry: TRF News, July 2022.

The article was featured also in the August issue of FCI In-Sight Newsletter, 2022.