As ESG Pressures Mount, Banks Must Incorporate Climate Risks into Their Stress Tests

Assessing new risks and outlining best practices for ESG-related stress tests

How would a hurricane in the Northeast US impact banks, many of which have large real estate loan exposure in the region?

That is one test the Federal Reserve Board posed to six of the country’s largest banks as part of its pilot climate scenario analysis (results are expected to be released at year’s end). But they’re not the only ones. Around the world, banks are under pressure from regulators, customers, investors, and the public at large to meet evolving environmental, social, and governance (ESG) criteria. So-called “stress tests,” like the Fed’s pilot program, can help, as can more material disclosures.

There is a way to go, however, when it comes to enacting these efforts. In the European Union, which tends to be ahead of the US in ESG-related initiatives, recent stress tests found that roughly 60 percent of banks do not yet have a climate risk stress-test framework.

The current economic landscape exacerbates this issue. Inflation, high interest rates, and risky commercial real estate (CRE) loan concentrations will raise the stakes. Should banks have to foreclose on these loans, emerging environmental risks and regulations could hurt their bottom lines even further.

Fortunately, banks can tackle these challenges head-on by transforming the way they conduct stress tests to estimate the financial impact they could face as a result of climate-related scenarios.

A Brief History of Banking Stress Tests

Since the Great Recession, banks have benefitted from an unprecedented period of artificially low interest rates and fiscal stimulus. This has allowed banks to take on riskier portfolios and ignore protective hedging against rising interest rates. The Dodd-Frank Act, which was designed to bring further stability to the banking system, increased stress-testing requirements for big banks but offered leniency for small and regional banks, which was expanded in further amendments. As a result of this lax economic climate, many of them rarely conducted stress tests—and some haven’t run them for years.

What’s more, many US banks that do run stress tests have yet to factor climate risk into their models. As noted above, the EU also has struggled to move the needle, an oversight which could end up costing the region’s banks close to $76 billion if the price of carbon emissions were to increase sharply and rapidly.

Fortunately, ESG-informed stress-testing pilots are picking up steam globally. The UK has pulled ahead, with the Bank of England publishing the results of its first climate stress tests for banks in 2022. As noted above, the Federal Reserve Board in the US has begun to conduct a pilot analysis geared toward the nation’s six largest banks. The Office of the Comptroller of the Currency is also hashing out formal guidance that would require lenders with over $100 billion in assets to consider their exposure to climate-related risks in their financial and capital planning and business strategies.

How Banks Can Mitigate ESG Risk With Climate Stress Tests

Whether a soft landing or break-the-bank scenario lies ahead, global banks need customized solutions that incorporate ESG requirements to proactively (and reactively) stress test their portfolios. But it’s not enough to throw a software platform together and call it a day.

 Any solution will have to do the following:

1. Grasp the full picture: Banks often have disparate systems that don’t communicate with each other. Other times, banks simply don’t have enough data to gain a holistic view of their portfolios and thus can’t run accurate stress tests. This can happen for any number of reasons: employees familiar with the portfolio leave the institution, acquisitions further complicate the number and diversity of investments, etc.

   For better oversight, banks must be able to assess the concentrations of different investments in their portfolios. They should know their major relationships, publicly available information from the Federal Deposit Insurance Corporation, credit policies, and loan-grading systems. They should also enlist the help of a consultant to conduct a peer-group analysis: a comparison of the bank with similar entities.

2. Collect the right data: To better integrate ESG factors into their stress tests, banks should access up-to-date, proprietary databases with environmental information. For example, the California-based company Property ID can create natural hazard disclosure reports for mortgaged properties that are at risk of flooding, wildfires, and other climate disasters.

   After banks have overlaid external environmental data points—the level of water contamination in a given area, for instance—with their own internal portfolio data, they can leverage advanced technology to assess the environmental risk of their portfolios. Tools like artificial intelligence and machine learning—when paired with smart subject-matter experts—can streamline this process and present valuable insights in an easy-to-use dashboard.

3. Bring in a regulatory perspective: Although regulators will monitor and review portfolios during the course of the year on an off-site basis, much of their review is based on subjectivity and trust. Don’t assume that because they’ve given a thumbs-up today they won’t levy fines later.

Operational challenges can add complexity. For instance, since regulators assess loan risk using a 10-bucket rating system, there’s incentive for the bank’s marketing function to push through loans that fall into the “just-pass” category in order to push deals across the finish line. This puts the bank’s marketing function in conflict with independent loan review function—as a result, monitoring loan risk becomes tougher.

Banks should obtain an outside perspective from multidisciplinary teams that have experienced numerous economic cycles and understand how regulators work. With their help, banks will be able to regrade loans that are under stress and develop a plan to ameliorate them over time. This goes a long way with regulators that, upon recognizing the bank has conducted a proactive analysis, may not force banks to write down those loans.

Now Is the Time for Banks to Future-Proof Their Portfolios

Whichever way the economy ultimately turns, the spotlight on ESG and climate-related risks will only grow bigger over the coming years.

And for good reason. Banks’ portfolios will be vulnerable to myriad risks related to climate change, from hurricanes and floods to decarbonization efforts and new environmental regulations. Even more arcane climate-related issues could have serious impacts: the central banks of the Netherlands and France, for example, found that 36 and 42 percent of their financial institutions’ investments, respectively, depend heavily on one or more ecosystems—meaning that the loss of biodiversity would substantially disrupt their businesses.

Incorporating ESG principles into their stress tests now will help spare banks from scrutiny in the future—and save them a significant amount of capital in the process.