ECB, ESRB report on climate change risks on EU financial sector

Within the report, ECB and ESRB underlined frameworks for minimising the risks faced by the financial system by collecting evidence on significant financial stability indicators through a surveillance framework that is complementary to Chartbook. The evidence was leveraged to create a macroprudential strategy for addressing climate risk, while also extending the scope from climate-related risks to increase broader nature-linked hazards.

As per the information detailed in the press release, the report comes as an addition to three previous ECB and ESRB studies on climate risk, with it being part of the ECB’s broader response to climate change.

ECB and ESRB found that banks have a substantial role in the financial system when managing and reducing risks to financial stability that occur from emissions of the EU economy. This is influenced by bank’s lending, as it is disproportionate to sectors with high exposure to climate-related risk. According to the report, the share of high-emitting sectors in bank lending is approximately 75% higher than its equivalent share in economic activity, resulting in an overrepresentation in banks’ loans for these sectors. Furthermore, 60-80% of all mortgage lending in the EU is also high-emitting households.

The topic of climate change is increasing in prevalence due to climate hazards continuing to expand in frequency and severity and as plans for a European green transition are more definite. By re-evaluating and repricing climate risk, the EU can develop financial stability via several channels with high exposure to climate-related risk. This encompasses the transmission of climate shocks through global value chains and the probability of financial contagion as banks and financial markets intend to reposition their asset portfolios against the environment of a substantial insurance protection gap. ECB and ESRB’s report developed the case for an enhanced macroprudential strategy to eliminate these risks, proposing a system-wide prudential approach that can focus on administering risks for the banking sector and borrowers. It would also reduce risks in non-bank financial intermediation, and gaps in insurance protection and information, including the need for reliable disclosures and green labels. The report highlights that it would also have the potential to complement the current macroprudential efforts, such as ECB Banking Supervision’s work on climate-related and environmental risk.

By leveraging this approach, the EU could draw on current instruments in its macroprudential suite, as systemic risk buffers and risk concentration limits facilitate the reduction of climate-related financial stability risk in a targeted and scalable manner. Moreover, the report analyses how the degradation of nature could potentially pose additional risks to financial stability, with the examination of exposures of EU financial institutions underlining that 75% of bank loans and 30% of insurer investments in corporate bonds and equity are in economic industries that rely on at least one ecosystem service, with particular emphasis on services related to surface and groundwater, mass stabilisation and erosion control, as well as flood and storm protection.