First Bank of England climate change stress test for lenders and insurers
This piece first ran as an expert comment at Warwick University’s News and Events on June 8, 2021.
By Dr. John H. Morris
"The Bank of England climate stress test is being undertaken now to provide a better understanding of the financial exposures of participants and the financial system to climate-related risks to financial stability. As such it foregrounds the Bank of England’s commitment to - and desire to be a leading figure of – the emerging consensus that central banks have a role to play in the transition to low carbon economies. This is something that Paul Langley and I have called “central banks as climate governors of last resort."
"Any ‘macroprudential’ stress test is designed to model the impact of hypothetical shocks on the regulatory capital held by banks. The point is to allow policymakers to assess banks’ resilience to a range of adverse shocks and ensure they are adequately capitalised. The 2021 Climate Stress test is an exploratory style test, which means that it is designed to investigate hypothetical financial stability threats that do not have empirical historical precedent. The stress testing exercise announced today features some noticeable differences to a ‘normal’ stress test.
This test covers a much wider range of institutions, because it includes the insurance industry in the exercise. This is important because banks often immediately assume that they can rely on insurers to cover climate-related losses.
The test considers a much longer, 30 year, time frame than the orthodox approach employed by the Bank.
Moreover, instead of just one scenario, the 2021 version employs three scenarios. Each scenario will imagine a political-economic future of ‘earlier’, ‘later’ or ‘no’ UK policy change and economic restructuring in relation to Paris Agreement temperature and emissions targets. Within each scenario are physical risks such as fires and floods caused by temperature changes, and more business oriented risks related to sudden changes in asset values and the price of carbon.
Finally, while the stress testing approach usually assesses the capital adequacy of banking groups, the 2021 test will allow the Bank of England to aggregate the results from individual institutions to better understand the aggregate effect of transition responses, or inaction, on the financial system
"While this stress test will almost certainly improve regulators’ understanding of the way firms are modelling risks and how climate related risks and the transition will impact firms' business models, the wider success of the test is uncertain because one never fully knows how participants, the specialist financial media and wider financial system will respond to a stress test.
"In the past, some testing exercises have not been considered plausible due to perceived problems with their methodologies. Researchers have already pointed out that some of the more granular methodological assumptions in the 2021 climate test are on the cusp of falling out of line with the approaches taken by other central banks and the catastrophe risk re-insurance industry. And, although the scale of market responses to tests are on a huge spectrum, the Bank of England is clearly operating with the logic that it is far better to start to catalyse the climate resilience transition in the finance sector, than to be put off by the risk aversion and conservatism that the central banking community is more commonly known for."
