Impairment expenses would be five times the base case, and dividends cut by in the order of 40 per cent, detailed modelling by banks of severe stress scenarios that combined high physical risks from climate change, such as flood and drought, with high transition risks.
Too Little Too Late was an apt label for the latest round of stress testing mandated by the Reserve Bank of New Zealand.
The key stress-test for New Zealand’s five largest banks in 2023 featured a scenario that tested their ability to withstand severe but plausible long-term climate-related challenges.
The losses sustained in the Climate Stress Test over a 20-year period would be higher than a combination of 4 years of losses from the RBNZ’s traditional stress test, plus benign losses over 16 years.
The 2023 Climate Stress Test builds on previous stress testing of climate-related risks: the 2021 Bank Solvency Stress Test which included drought as part of the scenario; the 2021 General Insurance stress test which included a series of severe storm events; and the 2022 risk assessment of bank’s residential mortgages to flooding and agricultural lending to drought and emissions pricing.
“We deliberately designed the climate stress test scenario to be challenging. It included high physical and transition risks over a prolonged period of 28 years. Our aim was to assess the financial impact of the scenario on the banks’ balance sheets and uplift their capability in managing climate related risks,” Kerry Watt, the RBNZ’s Director of Financial Stability Assessment & Strategy said.
“The results show that the ‘Too Little Too Late' scenario did not threaten bank solvency, as all banks were able to maintain their capital ratios” Watt said.
“However, it did highlight that climate-related risks have the potential to significantly reduce bank profitability, raise risk-weighted assets and reduce shareholders’ returns over the medium to long term. This tells us that climate related risks need to be actively managed to protect the resilience of the system to other shocks.”
The stress tests are generating plenty of follow up work. These include:
• improvements in modelling
• sourcing climate-relevant data
• informing insurance retreat impacts
• embedding climate expertise across each bank, and
• identifying strategic actions to mitigate the risks.
The RBNZ said “banks commented that while the exercise was resource intensive, it paid off by significantly improving capability and identifying areas of climate-related risks that need to be managed.”