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New stress test model shows climate risks for banks
Case study calculates declining equity ratios with CO2 pricing
In the future, European banks need to include risks caused by climate change in the stress tests on their equity capital. Prof. Dr. Gunther Friedl, Chair of Management Accounting at TUM School of Management, Prof. Dr. Sebastian Müller, Professor of Finance at the TUM School of Management, TUM Campus Heilbronn, and Alexander Schult, PhD candidate, have developed a new method for this in collaboration with the Frankfurter Institut für Risikomanagement und Regulierung (FIRM). In a case study, they used the stress test to analyze several scenarios of CO2 pricing. Due to greatly increased credit default probabilities of several industries, the bank examined would need to prepare itself for significantly decreasing capital ratios. The model can help banks prepare for future risks.
Climate change can cause substantial losses to companies, not only as a direct result of extreme weather events, but also through transitory risks, above all in the form of rising CO2 prices and long-term decreases in economic value creation. This, in turn, means greater risks for banks if companies are unable to service loans. Consequently, the European Central Bank (ECB) and the European Banking Authority (EBA) have ordered financial institutions to incorporate climate risks into their risk management and stress testing processes, which serve primarily to evaluate their capital buffers. The new requirement will take effect in 2022.
It is still unclear, however, how this requirement can be implemented. Nor is it certain what dimensions the transitory climate risks might reach in stress tests. Researchers at the Technical University of Munich (TUM) have therefore worked with the Frankfurt Institute for Risk Management and Regulation (FIRM) to develop a method that can be adapted to a variety of stress tests and have applied it in two case studies involving a bank and two investment funds.
Case study with 400 Euro STOXX companies
The model is based on a definition of transitory climate risks derived from recognized forecasts such as the Shared Socioeconomic Pathways (SSP), the resulting macroeconomic analysis for states and industries, and companies’ CO2 footprints. On that basis, the research team investigated around 400 companies listed in the Euro STOXX 600 index. They looked at four scenarios distinguished by different CO2 pricing levels (50 or 100 euros per tonne), the potential of companies to reduce CO2 emissions and the share of costs passed through to consumers. All of the scenarios assume an abrupt introduction of a CO2 tax.
Sectors with probabilities of default of 5–34%
The analysis shows that in every scenario around 10% of the investigated companies would face asset devaluations of more than 15%. In the most adverse scenario, 6% of the companies would see their assets devalued by over 30%. On a industry-by-industry basis, the assets of the six hardest-hit sectors would devaluate by 15–36%.
With these results, the researchers carried out a stress test on a major European bank. They began by calculating the rise in companies’ probabilities of credit default caused by the loss in asset values. In the most adverse scenario, 16% of the companies would have a probability of default of over 3%, which is considered high risk. The six most adversely affected sectors would have probabilities of default ranging from about 5% to 34%. Based on the bank’s so-called risk-weighted assets in relation to these corporate loans, the researchers calculated the effects on the bank’s equity.
Total capital ratio reduced by up to 1.6 percentage points
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