Essentially, while climate risk exercises are not dislocating banks, regulators are actively measuring it and revealing how disparate the results are within the industry.

Central banks have begun engaging with the industry with mechanisms to assess the financial impact of climate change, based on future climate scenarios, and determining whether the industry will be able to weather those.

On September 29 this year, the Federal Reserve Board in the US announcedi a pilot climate scenario analysis, to be launched in early 2023, with six of the nation’s largest banks participating.

Similar pilot exercises have been conducted by other central banks, such as the Bank of England (BoE) and the Bank of France. The European Central Bank (ECB) launched the 2022 Climate Risk Stress Test (CRST)ii in January to gauge the climate-risk preparedness of banks.

In this paper, we look closely at the key findings from the ECB 2022 CRST report and explore the challenges faced by the industry in its efforts to measure the financial impact of climate change, including the enhancement of methodological approaches, data consumption and emerging best practices.

Going forward, central banks’ climate risk measurement mechanisms may become an incrementally binding process. The ECB’s results from the 2022 CRST, for instance, will feed into the Supervisory Review and Evaluation Process (SREP), indirectly impacting Pillar II requirements which is how the ECB evaluates if the banks are well equipped to manage risks properly.

That said, banks should not be worried about the direct impact on capital requirements in the short term. Essentially, while climate risk stress exercises are not dislocating banks, regulators are actively measuring it and revealing how disparate the results are within the industry.

Our observations suggest that banks need to sharpen focus on climate risk and prepare their resources to support key business areas such as investment, credit, and operational risks to be future-ready. While central banks globally continue to deploy climate risk measurement mechanisms in a potentially incremental binding process, the industry, too, must consider increasing its preparedness to combat climate risk.