ECB Scores Win in Push to Prepare Banks for Climate Loan Losses

ECB Scores Win in Push to Prepare Banks for Climate Loan Losses

The number of European banks taking account of environmental risks in their reserves for loan losses has more than tripled in a year, signaling an initial win for the regulator in its effort to prepare for climate change.

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(Bloomberg) — The number of European banks taking account of environmental risks in their reserves for loan losses has more than tripled in a year, signaling an initial win for the regulator in its effort to prepare for climate change.

After the European Central Bank ramped up pressure last year, a wider effort to change how banks use so-called provisioning overlays has resulted in 55% of lenders now taking climate into account, up from 16% last year, according to a presentation by the regulator delivered last month to auditors and seen by Bloomberg.

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The ECB has led efforts to prepare banks for losses from extreme weather and from carbon-intensive clients struggling in a greener economy. Yet some of Europe’s lenders have pushed back, warning that extra environmental and climate buffers put them at a disadvantage to competitors in the US, where such demands don’t exist.

Read more: Bank Valuations at Stake as EU Splits With US Over ESG Risk

The central bank continues to face doubts from corporate auditors over the methodology and the necessity of the approach to overlays, people familiar with the matter said. They pointed to oft-cited concerns that banks don’t yet have sufficient data to base the overlays on and said that any provisions built for climate at this stage are likely to be relatively small.

An ECB spokesperson declined to comment. 

Accounting standards allow banks to build overlays, or reserves, for losses which are difficult to break down in detail, such as from the effect of lockdowns in the pandemic or interruptions to energy supplies after Russia’s full-scale invasion of Ukraine. The broad buffers “remain a material component” of banks’ provisioning for loan losses, according to the slides.

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The central bank has been pushing lenders to improve their data on future climate risks and, despite teething troubles, officials see the result as a vindication of their efforts. “This is a big success,” the ECB said in the presentation, and the task was “once considered impossible.”

Some banks map out scenarios for costs that could arise for companies forced to lower carbon emissions, according to the slides. If significant enough, such costs could call firms’ ability to service debt into question.

Novel Risks

Other lenders use a scoring system that “synthesizes the exposure of debtors” to such transition risks and physical events such as flooding or drought, or try to reflect them directly in underlying credit ratings with “qualitative elements,” the presentation shows.

Some auditors consider the ECB’s focus on climate provisioning as being disproportionate compared to other types of risks which are likely to show losses sooner, according to the people familiar with the matter.

The ECB’s presentation of a survey of 53 big banks shows that it is also focused on other so-called novel risks, namely those related to interest rates, inflation, geopolitics, energy and supply chains.

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“Overlays can be a proper tool to address novel risks in provisioning provided that they follow a clear and structured process and are backed by evidence,” the ECB said in the presentation. 

Claudia Buch, who took over as the ECB’s top oversight official this year, has said that one of her top priorities is to push banks to come up with more detailed plans for how they would respond to a range of emerging risks that could hurt their business. She has defended the ECB’s work on climate as being within its mandate.

Other findings of the ECB’s survey include:

  • An increasing number of banks rely only on so-called legacy macro-overlay models, which the ECB criticizes as being incapable of “differentiating the nuanced sectoral impacts of each novel risk”
  • Just 47% of banks have a interest rate overlays specifically for commercial real estate, which is notable because that means half of banks aren’t in line with ECB recommendations on CRE
  • Almost half of the banks don’t have an assessment in their overlays or in-model adjustments for when loans would move to a stage that’s classified as having higher credit risk

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