Macro-Stress Testing for Climate Risks and Green Finance Regulation

[Manal Shah is a policy researcher in the field of Indian financial regulation]

A recent study has ranked India as seventh most affected country by extreme weather events such as floods, storms and heatwaves. Another study conducted by the Council on Energy, Environment and Water (CEEW) indicates that 75% districts and half of India’s population are vulnerable to extreme climate events. In such a context, this post seeks to determine whether the efforts of India’s banking regulation towards climate resilience could benefit by beginning with a macro stress test for climate risks.

The Governor of the Reserve Bank of India emphasised the significance of climate-related risks in a speech recently:

Climate-related risks will be a focus area in times to come. Such risks will impact the business models of banks. The increased requirements of funding businesses and industry for tackling climate change would be greatly influenced by the global move on climate related risk management. … Banks are also increasingly aligning their businesses, including assessment of financing assets, with the global climate sustainability agenda. The need for banks would be to develop appropriate business strategies and strengthen the governance framework to gauge the associated risks. In line with international best practices, a forward-looking, comprehensive and strategic approach would be required to address climate risks.”

At this stage, it is pertinent to note that the world faced a number of significant natural disasters during 2021 causing over USD 343 billion in economic damage: cyclones Tauktae and Yass alone cost India a combined economic cost of USD 4.5 billion USD. The European Environment Agency recorded between EUR 450 billion and EUR 520 billion total economic losses by its members from weather and climate related events during a 41-year period (1980-2020). The United States (“US”) has recently acknowledged that economic harms from extreme weather and climate events have become more commonplace. In recent years, the US has experienced, on average, more than one disaster that has caused it over a billion dollars in damage each month compared to earlier periods.

All of these figures indicate that the time to implement effective climate risk management strategies is now, more so for India However, the peculiarities of climate risks have slowed the policy measures to manage them. Policymakers globally have observed that traditional risk management approaches are inadequate for measuring climate change-related risks. While effective policy making often requires a clear assessment of economic harms, predicting either immediate costs or long term implications for weather events is hard. This is because present models typically rely on historical data which, in this, case means looking to data informed by a climate that no longer prevails as CO2 levels are higher than ever and continue to increase exponentially.

Thus, it appears that the inadequacy of data and analytical capacity vis-a-vis climate risks is a key barrier in initiating effective supervisory reforms. It is suggested that a macro-stress test for system-wide analysis with supervisory objectives is what might be the need of the hour for resolving this conundrum. It is not necessary that the outcome of such a macro-stress test results in tightening of capital requirements, and the test can be used purely for exploratory purposes.

Stress tests have become increasingly in use since the 2008 global financial crisis. They are used by regulators to assess the resilience of regulated entities against a predefined set of risks. Central banks, including the RBI conduct stress tests covering the whole or part of the banking sector to monitor risks at the system wide level for financial stability assessments. Stress testing can be micro-prudential or macro-prudential, the former conducted by regulated entities (banks and non-banking financial institutions) and the latter conducted by the regulator at a system-wide level.

A macro-prudential stress test is designed to assess the system-wide resilience to shocks in the financial sector, which may include second-round effects emerging from linkages with the broader financial system or the economy. While information is gathered at firm level, the analysis provides information on risks and vulnerabilities across financial firms that could undermine the overall stability of the financial system.

While the incorporation of climate risks to a micro-prudential stress testing framework may be mandated at a later stage, it is imperative to prioritize a macro test. This exploratory and preliminary measure can be a starting point for managing climate-related risks and could be particularly useful in the beginning to identify and assess the risks. This can enable the RBI to achieve an understanding of the potential losses at banks, consequently enabling it to gauge the financial stability implications of climate risk based on facts and figures. This can be a learning opportunity for the RBI to identify vulnerabilities and exposures. It may also assist in designing policy measures pertaining to sectoral exposures and risk management for the later stage.

However, while it can be said that stress testing is forward looking, traditional stress tests are based largely on expected risks based on historical data. Climate risks are different and expected to increase with impacts materializing over a significantly longer time period. This aside, the lack of data and the unpredictability of climate change-related events by pattern make it harder to design a climate risk related stress test.

Notably, these concerns have also been studied and addressed by the Bank of International Settlements which recommends that the modeling techniques for climate risk macro stress test be composed of four parts:

  1. modelling the climate variables;
  2. measuring the impact of climate on macroeconomic variables;
  3. breaking down the overall macroeconomic impact across sectors; and
  4. quantifying the combined impact on financial firms.

Further, the RBI can use climate related stress testing undertaken in Netherlands, France, United Kingdom, European Union and Australia, to name a few, as case studies in devising its macro stress test. In addition to this, the Network of Greening the Financial Systems (NGFS), of which the RBI is a part, has also published suggested scenarios that can be used for such tests. Stress tests are seen as useful because of their forward looking nature and their flexibility.  A macro stress test for climate change would help in assessing future exposures and potential losses that cannot be extrapolated from past data.

A macro-stress test is further warranted for two reasons:

  1. the understanding put forth by the Basel Committee on Banking Supervision (“BCBS”) that existing financial risk categories that are traditionally used by banks and reflected in the Basel framework (i.e., credit risk, market risk, liquidity risk and operational risk) can be used to capture the impact of banks’ climate-related exposures; and
  2. the understanding put forth by the RBI Governor that various regulated entities are already taking climate risks into consideration.

Notably, the BCBS caveats its understanding with the need for further analysis to determine whether the climate-related financial risks are appropriately reflected in the current regulatory capital framework, and whether additional policy measures are required to address any potential gaps where warranted.

In order to design effective policy measures towards climate resilience of the banking segment, it is suggested that an exploratory macro stress test be conducted on a forward looking basis. In doing so, it is essential to keep India specific weather and climate risks into consideration and to assess the system’s overall vulnerability rather than determining bank-specific requirements.

Manal Shah

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