On 08 Jun, 2021, the Bank of England (BoE) published its Climate Biennial Exploratory Scenario (CBES) to assess the nature and severity of risks faced by the UK financial system as a result of climate change. This stress test will be UK’s first such system-wide assessment of these risks. It marks BoE’s efforts to establish climate risk as an integral part of each financial institution’s risk management process. Equipped with the submissions, BoE can develop an aggregate system-wide view of climate risk and formalise inclusion of this risk in the BoE’s own supervisory agenda.
The CBES is currently a requirement only for the 7 largest UK banks, the 10 largest insurers and 10 Society of Lloyd’s managing agents, with submissions due mid-October. Participating institutions will need to mobilise resource, build capacity in their stress testing infrastructure, especially their data and modelling capabilities, to complete this exercise in a timely and efficient manner. Our focus in this note is all UK banks and building societies.Even those banks that are not currently in scope for this exercise will benefit from tracking the challenges and recommendations covered here. The expectation is that these banks will need to address climate risk in their upcoming ICAAPs and Dear CEO letter responses. This stress test, along with the Dear CEO Letter on Climate Risk, is a further nudge to all PRA-supervised banking groups to review the impact of climate risk on their own business models.
The 2021 exercise focusses largely on implications for credit risk, along with a wider qualitative assessment of the overall business model impact; it is not positioned as a solvency or liquidity stress test. Nevertheless climate risk will have knock-on effects on several principal risks in banking. Solvency and liquidity considerations may therefore become relevant further down the road.
With the CBES postponed from 2020 to the second half of 2021, UK banks and building societies have had a bit more time to prepare for the CBES. Covid-19 responses will nevertheless have been the primary focus over 2020. So whole-hearted management backing, considerable resource and staff upskilling will be needed to develop a coordinated response on their climate risk management and stress testing commitments, especially so as for many banks this will overlap in part with the Annual Cyclical Scenario (ACS) solvency stress test cycle.
The novelty and complexity of the climate stress exercise, and the need to demonstrate progress in the space of a few months, will mean most institutions will find themselves stretched. While each institution's business model, footprint and climate readiness will differ, we identify four key challenges that should be relevant to most. In our view, these high-level challenges are:
- The timeline: Firms in scope for the CBES are subject to tight deadlines. With three scenarios to analyse and ongoing overlap with other regulatory risk management commitments, the ask is significant.
- The horizon: The stress test expects analysis over a 30-year stress horizon. For most institutions' strategic and business planning horizons, this is extraordinary. Planning so far out against the backdrop of highly uncertain climate outcomes and limited data introduces significant amount of uncertainty.
- The modelling: A response is needed for 3 complex climate scenarios with a large number of additional new variables needed to cover physical and transition risk. Even with the focus primarily on credit risk, most banks' risk systems will not have strategic solutions in place. Finding a balance between new and old models and quantitative and qualitative assessments will be key.
- The data: Firms will need to tap a wide number of data sources to cover their different portfolios, products and counterparties. While UK banks have been encouraged to do this for the last 2 years, this must come together in the space of the next few months
Deloitte’s 4 x 4
The attachment linked to this blog goes into further details on each of these. For each of the four challenges, it drills down into four further pointers. It then provides 16 recommendations – we refer to these as our 4x4. They should put you in the driving seat as you respond to the challenging terrain of climate stress testing.
While some items (especially timelines) are relevant only to banks (or insurers) participating in the 2021 CBES, most comments will be relevant to all banks that are in receipt of the Dear CEO letter as they look to address climate risk and scenario analysis in their ICAAPs over the course of the next two years.
“The end result will be more robust management of climate related financial risks across the sector,” Andrew Bailey, Bank of England Governor