Climate Stress Test assesses resilience of major NZ banks

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Director of Financial Stability Assessment & Strategy Kerry Watt says each year we run stress tests to assess banks’ resilience. The key stress-test for New Zealand’s five largest banks in 2023 featured a scenario called ‘Too Little Too Late' that tested their ability to withstand severe but plausible long-term climate-related challenges.

“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,” Mr Watt says.

“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. 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 test also improved banks’ capability in managing climate-related risks in several areas. These include modelling, sourcing of climate relevant data, informing insurance retreat impacts, embedding climate expertise widely across the organisation and identifying strategic actions to mitigate the risks.”

We have released a number of recommendations with our findings that include banks addressing significant remaining data gaps, continuing the development of credit risk modelling using climate-risk variables, and considering cost-effective ways of tracking the insurance status of mortgages. We expect all banks to reflect on these recommendations and are considering how we might support banks that did not participate in this stress test to incorporate them into their risk monitoring and management activity.

“It's important to recognise the Too Little Too Late scenario represents only one way New Zealand’s climate scenario could play out. Banks will consider others as part of their own internal risk management and to feed into mandatory climate-related disclosures. We would like to express our thanks to the banks that participated.”

The Reserve Bank will continue to play an active role in monitoring this work undertaken by entities as they draw on the learnings from our stress testing activities, our guidance on managing climate-related risks, and related supervisory discussions.

Questions and answers

Stress testing assesses the resilience of banks and insurers to severe but plausible risks, including economic downturns and in our 2023 Stress Test, climate-relate risks. The results of stress tests help us monitor financial stability, inform policy decisions and help entities improve their risk management capability, set capital and liquidity buffers, and identify mitigating actions.

We use annual stress tests across the banking and insurance to assess risks to individual entities and the broader financial system, inform policy decisions and help entities improve their risk management capability. Entities can use stress tests for risk management, capital and liquidity buffer setting, and strategy and investment decisions.

The climate scenario was developed in collaboration with participating banks, experts from industry, academia and government. We also consulted with fellow regulators who have conducted similar exercises including the Australian Prudential Regulation Authority (APRA), the Bank of England, the European Central Bank and the Network for Greening the Financial System (NGFS).

The Climate Stress Test is based on a severe but plausible scenario in which we specify how the New Zealand economy could be impacted by physical climate change and associated policies. For most of the detailed variable paths we have taken guidance from scenarios developed by the NGFS. The NGFS scenarios sit in an overarching framework, differentiated according to the severity of transition and physical risk. We decided to design a scenario with high physical risk and high transition risk to give us additional insight to that gained from other regulators’ stress tests which generally focussed on either physical or transition risk. Because the NGFS scenarios at the time, NGFS Phase III, contained either high physical or high transition risk, we combined the effects of two NGFS scenarios — one of each type — in our scenario design. We refer to the RBNZ scenario as ‘Too Little Too Late’ (TLTL) because in this scenario limited and delayed global policy action to reduce greenhouse gas (GHG) emissions is insufficient to prevent significant climate change.

We wanted to design a scenario which combined high Physical and High Transition climate-related risks. At the time, there were no NGFS scenarios available which exactly suited our needs. Instead, we combined the effects of two NGFS scenarios — one of high physical and one high transition risk — in our scenario design.

NGFS in November 2023 published its ‘Phase IV’ scenarios, which include a scenario in the with both high physical and transition risks. This new NGFS scenario, named ‘Fragmented World’, has a similar overall narrative to our own Too Little Too Late scenario: “It explores more adverse impacts as a result of climate policies being implemented in a fragmented manner, both intertemporally and geographically, meaning that countries delay the implementation (‘too late’), and then diverge in their mitigation stringency, rendering efforts overall insufficient to reach net zero (‘too little’).”

While this scenario was designed to be severe, including a combination of plausible physical and transition climate-related risks, it is only one hypothetical scenario among many possible ways that climate-related risks could play out in the coming decades. Stress test scenarios are not intended to be used as a predictive tool, their purpose is to explore how risks might plausibly evolve.

The name of the scenario comes from a framework that the NGFS developed for categorising climate scenarios according to the severity of physical risks and transition risks. In this framework, ‘Too Little Too Late’ refers to scenarios with a combination of high physical risks and high transition risks. In our scenario, limited and delayed global policy action to reduce greenhouse gas emissions is insufficient to prevent significant physical climate change, so it fits into the ‘Too Little Too Late’ category and the name suits the narrative of the scenario. However, we recognise that there are a range of potential scenarios that could be developed within this NGFS category, over various time horizons.

Climate change is widely acknowledged to pose a range of risks to the financial system. These risks are typically characterised as physical or transition related. Physical risks result from climate change itself and can be driven by an increased severity and frequency of natural disasters (acute risk) and by gradual changes in climate patterns, such as higher temperatures (chronic risk). Transition risks result from the adjustment of societies and economies towards net-zero operation. These risks can arise on account of policy measures (for example greenhouse gas taxation), new technology and innovation, litigation, and changes in consumer preferences.

No. 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.

Our traditional stress test scenario which features a severe economic downturn creates much higher losses over the four-year period than a four-year average of losses during the Climate Stress Test. The sharp losses from our traditional stress test significantly reduced bank capital ratios. The sustained losses of the Climate Stress Test, whilst not challenging capital ratios, significantly erodes shareholder value over time. (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 our traditional stress test plus benign losses over 16 years.)