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BoE outlines climate stress test for insurers

It is the first time it is testing both banks and insurers in order to allow it to ‘capture interactions between them and understand the risks presented by climate change across the financial system’

The Bank of England (BoE) has published the Climate Biennial Exploratory Scenario (CBES) to explore the financial risks posed by climate change for the largest UK banks and insurers.

The BoE said the CBES uses three scenarios of early, late and no additional action to explore the two key risks from climate change: the risks arising from the significant structural changes to the economy needed to achieve net zero emissions – ‘transition risk’ and risks associated with higher global temperatures – ‘physical risks’. 

It is also the first time it is testing both banks and insurers in order to allow it to “capture interactions between them and understand the risks presented by climate change across the financial system”.

The BoE said the objectives of the exercise are to:

  • Size the financial exposures of individual firms and the financial system to their end-2020 balance sheets: this will shine a light on risks that are currently opaque;
  • Understand business model challenges and likely responses to these risks: this will highlight where action may be needed and any implications for the provision of financial services, and
  • Improve firms’ risk management and prompt a strategic view: this includes building capability, both amongst participants and within the Bank. The exercise will also encourage participants to engage their largest counterparties to understand their vulnerability to climate change.

It also confirmed the CBES is an exploratory exercise and  will not be used by the bank to set capital requirements. Instead, participants’ submissions may inform the Financial Policy Committee’s future approach to system-wide policy issues, and the Prudential Regulation Authority’s (PRA) future supervisory approach.

The key features of the CBES are:

  • Three scenarios of early, late and no action built on a subset of the Network for Greening the Financial System (NGFS) scenarios: these are applied over a span of thirty years reflecting the longer-term nature of climate-related risks;
  • Sizing the risks participants face based on their current (fixed) balance sheets: for banks, the exercise will focus on their credit books, whilst for insurers, the exercise will assess risks to both their assets and liabilities;
  • Qualitative questionnaire: this will capture participants’ own views on their risks, their approach to climate risk management, and their potential management actions, and
  • Detailed counterparty-level analysis for the largest counterparties: the CBES asks firms to use novel modelling approaches to conduct a detailed, bottom-up analysis of their largest counterparties. For the remainder of counterparties, firms are expected to differentiate exposures by geography and sector.

The BoE added that it intends the CBES to be a learning exercise and will use it to develop the capabilities of both the Bank and the CBES participants.

Andrew Bailey, the Governor of the Bank of England, said: “Today’s exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole. It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks. 

“It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”

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