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December 20, 2019

Climate stress-testing coming soon

 The new governor of the Bank of England is due to be appointed later today The FT reports that Andrew Bailey, chairman of the Financial Conduct Authority, is now the firm favourite, while other previous front-runners have now been firmly ruled out, in part because of their views on Brexit.

As for now we would like to draw your attention to the Bank of England’s announcement of a two-year climate stress test of British banks. The first part of the exercise is a public consultation around a discussion paper on the methodology for the actual stress test to be carried out in 2021. This kind of stress test is not something banks are used to, and so banks and supervisors will be working also on figuring out how to do the reporting and the risk modelling for it in the first place. One of the biggest challenges in the climate stress test is the time horizon of several decades, which contrasts with the horizons of several years that are used normally in bank stress tests. The Bank of England will be using a static-balance-sheet approach, which doesn't seem a very sensible assumption over a horizon of several decades. But the alternative, to model the evolution of the balance sheet over such a long period, is even less satisfactory. This is the kind of difficulty inherent to this type of tests. The static balance sheet approach at least will provide a signal to banks and supervisors about whether banks are overexposed to certain risks, and indications about how banks may steer the composition of their balance sheets in the future as awareness of climate risks improves.

For us at Eurointelligence, however, the question becomes whether the eurozone must or will do something similar. Marc Carney, in a Financial Times op-ed calls on other central banks to follow the Bank of England's lead. So, what is going on in the EU banking union in this regard?

First, barely two weeks ago the European Banking Authority released its own action plan on sustainable finance. As the EBA is the EU's banking regulator, this is the necessary first step for any sustainability-related banking stress test. The EBA's action plan comprises three stages. The first will focus on sustainability risk measures, including their reporting and disclosure, bank strategy and governance around them. The second stage will be carrying out a proper sustainability stress test. These two stages will take longer than the two years the Bank of England is giving itself for the stress test. The third stage of the action plan will be to incorporate sustainability risk management into actual bank regulation and supervision.

The EBA is giving itself until 2025 to complete this action plan. A discussion paper will be published around the middle of next year, with the aim to complete the first stage on risk reporting and strategy by June 2021. The EBA will conduct a voluntary sensitivity analysis on sustainability risks in the second half of next year. A fuller stress test will follow at a later date.

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