20 April 2024

Supervisory pilot reveals moderate exposure to climate risks

Banking & Finance
| The European |

The first assessment of financial risks stemming from climate change performed by French banking supervisory authorities showed that French banks display moderate exposure to climate risks

Participation was voluntary so the results will not translate into any regulatory actions or requirements for corrective measures. “But we believe the increased momentum around climate stress tests for financial institutions matters more than the outcome of the exercise,” said Nicolas Hardy, executive director in Scope’s financial institutions team. “We see value in linking banks’ expected financial performance to environmental risk.”

The French pilot focused on banks’ exposure to the two subsets of climate risk: transition and physical risk. As an exercise, it fed into efforts being undertaken by the Network for Greening the Financial System to highlight the transmission channels between the emerging physical and transition risks of climate change and the traditional financial risk taxonomy developed under the Basel capital adequacy framework for credit, market, and operational risks.

The overall ‘moderate’ impact of climate risk on French banks’ credit quality can be explained by their geographic and business exposure. The most sensitive exposures represent a relatively small part of total lending, accounting for only 9.7% of corporate portfolios. The test also identified ‘winning’ sectors i.e. those that would experience a decrease in probabilities of default such as the construction sector, for which transition is an opportunity. “The net impact of transition risk on credit costs will depend on transition patterns (orderly, delayed, sudden), but it remains below 20bp which is low in our view,” said Hardy.

A major benefit of climate stress tests is creating a dedicated timeframe for measuring climate risk. In the meantime, the need to model risks over an extended time horizon creates additional hurdles in comparison to traditional stress test exercises, which are usually limited to shorter time horizons. “Given this extended timeframe and unlike traditional stress tests, the climate stress test allows for corrective measures to be integrated in the form of management actions, and the modelling of dynamic balance sheets, like corporate portfolio re-allocation,” Hardy said.

From a credit rating perspective, identifying the most sensitive corporate sectors and reviewing strategies to adapt to climate risk are direct inputs into bank credit rating analysis. The pilot highlighted the challenge of setting the most relevant criteria for sector identification, which at this stage may lack sophistication. Looking for the sectors that are the larger contributors to greenhouse gas emissions (volumes) produces different results to focusing on the potentially bigger financial risk associated with the introduction of a carbon tax.

Banks will apply a variety of strategic options to limit credit risk. They range from the strict early application of an exclusion policy to a more inclusive credit policy to accompany clients as they transition. “In our view, there is no one size fits all strategy to optimise for credit risk arising from climate risks,” Hardy said.

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