Climate shocks and banking sector

Climate change has become a grave concern worldwide as there is no way to prevent or avoid it. The consequences of climate change are the rise in temperature, intense droughts, water scarcity, severe fires, rising sea levels, flooding, melting polar ice, catastrophic storms, and declining biodiversity. The change affects human health, ability to grow food, housing, safety and work.  Billions of people are already more vulnerable to climate impacts, and more will be affected in the near future. For instance, conditions like sea-level rise and saltwater intrusion have reached the point where whole communities have had to relocate, and protracted droughts are putting people at risk of famine. Scientists predicted that the number of people displaced by weather-related events will rise soon.

Various global and regional initiatives are underway to mitigate and adopt climate change. Scientists and environmentalists have already conducted several research studies on this topic. They are also exploring new viewpoints to study the impact of climate change. Central banks have joined the move by introducing climate stress tests on banks and financial institutions to address climate-related risks to the financial system.

Stress tests are ‘assessments of how well banks can cope with financial and economic shocks’. The tests allow supervisors or regulators to identify banks’ vulnerabilities and work with those institutions to address them. Stress testing is one of the measures institutionalised by the Basel Accords after the 2008 global financial crisis to reduce economic damage from banks taking too much risk. The second pillar of the Basel Framework reinforces the first pillar by setting minimum capital requirements to determine whether banks require additional capital buffers to withstand stressed situations.

Climate stress tests are a new tool for assessing banks’ resilience to transition risks arising from new policies and technologies and physical risks due to acute and chronic extreme weather events. They are based on ‘different predictions of the policies that might be implemented and the ability of those policies to prevent critical temperature thresholds from being breached.’

The use of the new tool is still limited. The European Central Bank conducted an economy-wide stress test in 2021, and launched its first climate risk stress test for individual banks in January 2022. Bank of England (BoE), Federal Reserve, People Bank of China and some other leading central banks also conducted one or more climate stress tests in last three years.

Taking a cue from the global exercise, Bangladesh Bank also conducted the country’s first climate stress test last year, assuming that the country’s financial system may face significant challenges from climate-induced gross domestic product (GDP) slowdown in the coming years. The central bank also released the outcome of the exercise last month titled ‘An Exploratory Report on Climate Stress Testing for…