As ESG Pressures Mount, Banks Must Incorporate Climate Risks into Their Stress Tests

Assessing new risks and outlining best practices for ESG-related stress tests

How would a hurricane in the Northeast US impact banks, many of which have large real estate loan exposure in the region?

That is one test the Federal Reserve Board posed to six of the country’s largest banks as part of its pilot climate scenario analysis (results are expected to be released at year’s end). But they’re not the only ones. Around the world, banks are under pressure from regulators, customers, investors, and the public at large to meet evolving environmental, social, and governance (ESG) criteria. So-called “stress tests,” like the Fed’s pilot program, can help, as can more material disclosures.

There is a way to go, however, when it comes to enacting these efforts. In the European Union, which tends to be ahead of the US in ESG-related initiatives, recent stress tests found that roughly 60 percent of banks do not yet have a climate risk stress-test framework.

The current economic landscape exacerbates this issue. Inflation, high interest rates, and risky commercial real estate (CRE) loan concentrations will raise the stakes. Should banks have to foreclose on these loans, emerging environmental risks and regulations could hurt their bottom lines even further.

Fortunately, banks can tackle these challenges head-on by transforming the way they conduct stress tests to estimate the financial impact they could face as a result of climate-related scenarios.