Climate Change Creates Risks To Both The Safety And Soundness: Economic And Regulatory Capital Report Writing, UOL, Ireland

Climate change creates risks to both the safety and soundness of individual firms and to the stability of the financial system. These risks are already starting to crystallize, and have the potential to increase substantially in the future. There is a pressing need for central banks, regulators, and financial firms to accelerate their capacity to assess and manage these risks.

To facilitate this, the Bank’s April 2019 Supervisory Statement set out expectations for UK banks(1) and insurers to develop and embed climate risk management practices, including by undertaking scenario analysis. To develop this field, the Bank will use its 2021 biennial exploratory scenario (BES) to explore the financial risks posed by climate change. The BES is part of the Bank’s stress testing framework used to explore less well-understood risks that are not neatly linked to the financial cycle.

The objective of the 2021 BES is to test the resilience of the current business models of the largest banks, insurers, and the financial system to the physical and transition risks from climate change. The exercise will provide a comprehensive assessment of the UK financial system’s exposure to climate-related risks and therefore the scale of adjustment that will need to be undertaken in coming decades for the system to remain resilient.

To this end, the BES will focus on sizing risks, rather than testing firms’ capital adequacy or setting capital requirements. It will also allow the Bank to examine how major financial firms expect to adjust their business models, and what the collective impact of these responses on the wider economy might be. Finally, the BES will provide a vehicle for financial firms to identify and address data gaps and to develop cutting-edge risk management approaches.

This discussion paper sets out the Bank’s proposed framework for conducting the 2021 BES. Given the unique nature of climate-related risks, the 2021 BES will be a novel exercise for the Bank and for participating firms. As a result, the proposal differs from traditional stress tests in several areas:

• Multiple scenarios: the BES will test the resilience of individual firms and the financial system to three climate scenarios. These will include scenarios that embody the risks of earlier and later policy action to reach the Paris Agreement target, and a ‘no additional policy action’ scenario where the Paris Agreement target is not met and more severe physical risks crystallize as a result.

• Broader participation: the BES will test the resilience of both the UK’s largest banks and insurers to climate-related risks. Insurers will participate via a BES-aligned Insurance Stress Test in 2021. This broader participation aims to test climate-driven financial risks across the system and to gather insights on spillovers within the financial system.

• Extended modeling horizon: the BES will use a 30-year modeling horizon. This is because climate change, and the policies to mitigate it, will occur over a much longer timeframe than the normal horizon for stress testing. To make these scenarios credible and tractable, the Bank proposes that the BES examine firms’ resilience using fixed balance sheets, focusing on sizing the risks and the scale of the business model adjustment required to respond to these risks, rather than testing the adequacy of firms’ capital to absorb those risks.

• Integrated climate and macro-financial variables: the Bank will provide pathways for temperature, emissions, and climate policies to capture the underlying physical and transition risks in each scenario. The Bank will also provide a consistent set of macro-financial variables to enable firms to model the impact of the scenarios.

• Counterparty-level modeling expectations: firms will assess the vulnerability of individual counterparties’ business models to the underlying climate-related risks in each scenario.