Stressed about Climate Change?

Each year the Bank of England undertakes stress-testing on major UK banks, building societies and insurance companies, assessing their financial resilience and ability to cope with extreme economic scenarios and market shocks. These exercises help inform the levels at which the PRA sets the capital buffers banks must hold and are an important supervisory tool for the BoE to understand the strength of the banking sector.

Arlingclose clients will be familiar with the regular bank stress testing as we report on the results as part of our creditworthiness service. What is perhaps less widely-known is that every other year the BoE undertakes additional stress testing intended to explore the resilience of the banking system to risks that are less understood and not so easily linked to economic and financial cycles – this is called the biennial exploratory scenario (BES). Previous BES tests have looked at persistently low interest rates and liquidity risk, although the results of 2019’s liquidity BES have yet to be published due to the Covid-19 pandemic.

The Bank has recognised the pressing need for central banks, regulators and financial firms to accelerate their capacity to assess and manage climate risks. Therefore in 2021 the BES will be focussed on risks to the financial sector from climate change (and for fans of acronyms, this is being referred to as CBES, the Climate Biennial Exploratory Scenario). The objective of the CBES is to test the resilience of the major UK banks and financial system to physical and transition risks from climate change, assess the wider system’s exposure to climate-related risks, and therefore the scale of adjustment that will be needed in coming decades for the system to remain resilient.

In June this year, the Central Banks and Supervisors Network for Greening the Financial System (a group of 66 central banks) published a set of climate scenarios to provide a common starting point for analysing climate risks to the economy and financial system. These will serve as the basis for the scenarios for the CBES. There will be three main climate scenarios:

• Orderly: Early, ambitious action to move to a net zero CO2 emissions economy
• Disorderly: Action that is late, disruptive, sudden and/or unanticipated
• Hot house world: Limited action leads to a ‘hot house’ world with significant global warming and, as a result, strongly increased exposure to physical risks

Given the unique and complicated nature of climate-related risks, the BoE has been open about the fact that the CBES will be a novel exercise for the Bank and the participating firms. The exercise will focus on sizing risks, rather than testing individual firms’ capital adequacy or setting capital requirements as is the case with the standard stress tests.

The scope and breadth of the CBES mean that it is a pioneering exercise and no doubt much will be learned. It’s hoped that the exercise will also provide a vehicle for financial firms to identify and address data gaps and to develop cutting-edge risk management approaches.

CBES is due to be launched in June 2021 with the results expected in Q1 2022, so it will be some time before we get the most comprehensive view so far of how exposed the UK financial system is to climate change. In the meantime, our clients are increasingly considering how environmental and social issues can be effectively incorporated into their approach to treasury management. While this is not a straightforward task, the BoE’s work on climate change will be another useful resource.