Over the past few years, banks and financial institutions around the world have been focusing on reducing the impact of financial risks owing to climate change on their businesses.
This paper categorises climate change-induced risks faced by banks and insurers and details the measures that could be taken to quantify them. It also proposes an alternative stress-testing framework.
Our starting point is the Bank of England (BoE)’s 1discussion paper published in December 2019, which frames a climate risk management proposal for UK banks to undertake under the 2021 Biennial Exploratory Scenario (BES). The primary goal of BES is to test the resilience of current business models of large banks to physical and transition risks from climate change.
To deal with plausible climate scenarios, banks and insurers (‘firms’) have to understand potential risk and financial stability implications, manage climate change risks, and draft policies in accordance with such scenarios. The key objectives of BES are to: a) measure the financial exposure of a firm significantly prone to climate change, and b) evaluate the response to each potential climate scenario and gauge how the firm plans to mitigate potential losses, make adjustments to business models, and undertake remedial actions. The BES will focus on sizing risks rather than setting up capital requirement for banks, review business model adjustments, and help banks enhance stress- testing approaches. This will help banks and insurance firms effectively measure and model climate change-induced financial risks to safeguard them from potential losses.
The BoE’s discussion paper also aims to capture the impact of BES on banks and insurers and get feedback from them on the proposed framework’s feasibility and robustness.
The objective of this paper is to explain key highlights of the BoE’s prescribed climate risk stress-testing framework for further consultation and potential challenges to the climate risk scenario modelling exercise.