Banks face climate stress tests as APRA calls for improved internal systems

Big banks face annual stress tests focused on climate change, as regulators say they need better internal systems to gauge risks.

Banks will face stress tests to take stock of their vulnerability in the face of global warming. Picture: Getty Images

The prudential regulator will push Australia’s biggest banks through a round of stress tests focused on “climate change financial risks” that will gauge the ability of financial institutions to weather potential shocks from a warming climate or the transition to a low-emissions economy.

The announcement, confirming a series of reports by The Australian last year, came as the Australian Prudential Regulation Authority, warned smaller lenders they had “less sophisticated” preparations for dealing with economic shocks.

APRA on Friday confirmed it will adopt a series of stress tests that will take stock of the vulnerability of banks to changes in asset prices brought on by global warming or policies to limit emissions, alongside annual financial health checks on bank’s resilience in the face of financial shocks, failures in governance and other non-financial risks.

The regulator has also signalled new climate change scenarios will be included in an industry consultation on stress-testing in the second half of 2020, which industry sources believe could spark a debate over which assets on the books of banks, insurers and superannuation funds are most vulnerable to climate change.

The Australian last year reported APRA and the Reserve Bank were working with international central banks and regulators on a number of climate scenarios that could be adapted in Australia to check if the local financial system was prepared for potentially wild fluctuations in markets brought on by policies aimed at lowering emissions or due to economic shocks created by climate change.

The Australian economy is already grappling with the fallout from the bushfire crisis, which has now been compounded by a hit from the coronavirus.

An index tracking business activity published by the Commonwealth Bank on Friday showed the coronavirus crisis and the bushfires over summer sparked the sharpest contraction in the local services sector on record.

In a letter outlining the findings from its review, APRA deputy chair John Lonsdale said larger banks, known as group one, had far better developed internal stress-testing abilities than smaller Australian lenders, in group two, which included a number of mutual, customer-owned lenders, and subsidiaries of international banks.

However, Mr Lonsdale said “both groups would benefit from better coverage of non-financial and emerging risks”.

“To complement the ongoing improvement in stress-testing capabilities and application, APRA is moving towards greater frequency and depth of stress-testing for (banks),” Mr Lonsdale said.

“This includes transitioning in 2020 to annual stress-testing of large (banks). APRA also plans to test resilience to broader scenarios, including the impacts from operational and climate change financial risks,” he said.

Because APRA found “areas for ongoing improvement in stress-testing for all entities”, the regulator will develop new guidelines for stress-testing, which will be the subject of a consultation in the second half of 2020.

As revealed by The Australian in December, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), chaired by former Bank of England Governor Mark Carney, is due to finalise a number of climate transition scenarios in the first half of 2020, at which point APRA will begin tuning the economic models to the local context to begin stress testing large financial institutions.

Former Bank of England Governor Mark Carney. Picture: Getty Images

Regulatory sources have confirmed to The Australian the running order for the sectors soon to face an Australian prudential probe measuring the exposure of banks, insurers and super funds to both the physical risks of climate change — such as floods, droughts, fires or cyclones — and the economic “transition” risks, such as orderly or abrupt changes in prices, possible stranded assets, or long-term productivity changes.

Australian banks will be the first sector in the firing line for the prudential regulator’s tough new institutionally-focused climate change stress tests, followed by the $45bn general insurance sector, before superannuation fund managers overseeing the nation’s $3 trillion pile of retirement savings feel the heat of APRA’s soon-to-be-launched climate stress test.

As part of its review of internal stress-testing capabilities across 28 of Australia’s major and second-tier lenders last financial year, APRA focused on banks’ governance, scenario development and the use of internal stress-testing to monitor the strength of their capital buffers and their resilience during unexpected economic and financial shocks.

Group one banks, which included Commonwealth Bank, Westpac, National Australia Bank, Macquarie, ANZ, AMP, Bank of Queensland, Bendigo Bank, ING, had formalised governance structures, clear roles and accountabilities, and documentation to support most aspects of their stress testing process, APRA said.

“The frameworks, however, were not always subject to regular independent reviews,” the regulator said.

Group two banks, which included Bank Australia, Heritage Bank, Credit Union Australia, Teachers Mutual, Bank of China, and ME Bank, “generally did not have specific frameworks for stress testing”, APRA said.

The bigger banks “typically had broader engagement across the organisation in their stress testing activities”, while stress parameters and impacts “were generally well considered, and scenarios typically covered all or most material risks identified by the entity,” APRA said.

The regulator said smaller banks had processes that “tended to be less structured and integrated” and “their scenarios and stress parameters were typically designed with less sophisticated considerations”.

“The role of stress testing appeared much less prominent in group two,” APRA said.

The Bank of England last year said it would measure UK financial companies against three climate change scenarios, which were under development by the NGFS.

These include a “catastrophic” business-as-usual scenario where no further climate action is taken, a scenario where early policy action delivers an orderly transition to the targets set in Paris, and a third where late policy action leads to a disorderly and disruptive transition, Mr Carney said.