Climate Change Stress Testing for the Banking System

Abstract

717It is apparent that climate change is creating financial risks. These risks are of such a nature that they can be regarded as systemic: they are exogenous shocks which may simultaneously cause or contribute to the failure of multiple significant financial institutions. As a result, regulatory tools available to monitor and manage systemic risk have recently been deployed in the context of climate change risks. Such tools include stress testing and scenario analysis. This article examines international initiatives, such as those of the Network for Greening the Financial System, as well as specific central bank initiatives including those by the Bank of England. After some initial observations around climate data, stress test design, and central banks’ mandate, this paper continues to discuss further possible inclusion in the prudential regulatory framework. In particular, the question is raised if capital requirements should be adjusted and if changes should be made to the risk management and governance framework. This paper argues in favour of the latter, but is more cautious as regards the former.