Banks’ loan-loss forecasts diverge in BoE climate exercise

Dispersion of estimates for corporate impairments highlights variety of assumptions for modelling climate risk

UK lenders participating in the Bank of England’s (BoE) latest climate risk simulation forecast wildly divergent loan-loss trajectories in a transition to net-zero, highlighting how modelling remains in its infancy despite the urgency to decarbonise balance sheets.

As part of its second Climate Biennial Exploratory Scenario, the UK regulator asked seven lenders to estimate how much corporate credit impairment rates would increase as policies to contain global warming are pushed through, under both an ‘early action’ (EA) scenario, where measures are implemented immediately, and a ‘late action’ (LA) scenario, one where the transition only begins in 2031.

 

 

Across lenders with common counterparties, estimates of the increase in loss rates – compared with a counterfactual scenario that strips out climate risk – averaged 6.4% under EA and 6.8% under LA.

But if the most conservative forecast for each shared counterparty were applied across all of the banks’ exposures vis-à-vis that same counterparty, loss rates would surge more than twice as much – by 14.6% under EA and 15.1% under LA. Conversely, using the lowest submitted projection for each counterparty, collective impairment rates would only rise by 1.5% under EA and by 1.7% under LA.

Counterparties common to at least two lenders accounted for around a fifth of participating banks’ overall exposures.

What is it?

The BoE runs thematic exploratory scenarios every two years, alongside its annual stress test. The latest exercise examines the impact of climate change and the policies introduced in response to it on the UK financial system.

The exercise uses three scenarios: early action, which assumes governments phase in measures beginning 2021 to reach net-zero carbon emissions by the mid-century; late action, which sees those measures being belatedly implemented in 2031, in a rush to meet net-zero by 2050; and no additional action, where no further policies are adopted beyond those in place as of this year.

The exercise makes use of variables associated with physical risk – those linked to higher global temperatures likely to result from taking no further policy action – and transitional risk, which arises from the significant structural changes to the economy needed to achieve net-zero emissions.

Traded risk and non-traded market risk are out of the exercise’s scope. The BoE does not use the exercise’s results to set capital requirements.

The banks that participated in the exercise are Barclays, HSBC, Lloyds Banking Group, Nationwide Building Society, NatWest Banking Group, Santander UK and Standard Chartered.

Why it matters

No matter how many lenders a corporate borrower has, its lines of credit are all serviced through the same cashflow. And while banks’ may know how to gauge that cashflow’s resilience to drops in employment and GDP, their assessments clearly diverge when it comes to the same borrower’s ability to deal with higher carbon prices and green capital expenditure.

The BoE said it intentionally designed its climate exercise in a way that enabled participants to take a range of approaches, meaning dispersed results were not, in themselves, unwelcome. An actual climate stress test would likely see the BoE set specific restrictions and guidelines around modelling, since comparability of results would be paramount.

But the BoE’s explicit hope is that lenders will use the exploratory exercise’s findings to hone their climate risk modelling – through better data, more granular models and a deeper understanding of borrowers’ exposure to climate risk.

After all, unlike the hypothetical downturns that undergird traditional stress tests, climate change is a certain future development. The only uncertainty is around how well-prepared banks are to handle it.

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