Bank stress-testing to spotlight climate risks
Meanwhile, our financial system has until recently relied almost entirely on its own insular set of ‘standard models’ to predict outcomes. The ‘efficient markets hypothesis’, for instance, and the related Capital Asset Pricing Model (CAPM) often form the basis of risk-and-return forecasts for share investors (among others).
Credit analysts, similarly, have an array of statistical tools and assumptions to weigh up the relative risks and returns of fixed income portfolios.
Of course, the standard models of finance are more art than the science practised by particle physicists but investors as a rule base their faith, and capital allocation, on these statistical analyses of market risks.
For all their internal mathematical robustness, however, financial models cannot contain all risks in their formulae – as history has a habit of proving. The 2007-8 Global Financial Crisis (GFC) was undoubtedly the most significant recent reminder that investors can’t ignore the ‘dark matter’ of markets, exerting its invisible influence beyond the boundaries of standard deviations.
Despite the systemic shock, the GFC had at least one positive side-effect in prompting regulators and investors to explore alternative models that probe risks on the fringes of the bell-curve where the fat-tailed black swans gather. The crisis saw scenario- or stress-testing rise to the fore as a tool to examine what could happen under the darkest possible circumstances.
In his aptly titled GFC memoir ‘Stress Test’, former US Treasury Secretary, Tim Geithner, points out why regulators and risk managers need to “set aside assumptions about implausibility of a major shock and study the impact of that shock if it somehow happened”.
Geithner’s warning applies just as equally to risks emanating outside the traditional financial system where the scenario-bending force of climate change is now being taken seriously by regulators, investors and the public.
Led by regulators across the world, companies and institutional investors are rapidly incorporating climate risks into their financial forecasts and strategies. The formal assessment of climate risk in financial projections is accelerating particularly in countries, or regions, where governments have put in place clear environmental policies. Europe is probably the global leader in driving the climate risk-testing agenda where French financial institutions were the first to report results according to new guidelines in April this year.
Climate scenario-testing has now evolved to consider financial risks across three broad categories, as illustrated in figure 1.
Figure 1. Taxonomy of climate risks
Source: Federated Hermes (elaborated on various sources NGFS, ECB, DNB, ACPR, BoE and Apra), as at July 2021.
Most regulators are developing climate-reporting rules in their respective jurisdictions based on the climate scenarios and guides published by the global Network for Greening the Financial System (NGFS).
The European Central Bank (ECB) is set to test significant banks in the region for climate risks in 2022 with regulators in Australia, Brazil, Canada, Hong Kong, and Singapore announcing similar exercises either this year or next.