How do banks incorporate climate risk into their stress testing frameworks, and what are the key scenario types?

Climate risk stress testing is an emerging but increasingly mandatory practice where banks assess the financial impact of climate-related scenarios on their portfolios. It differs fundamentally from traditional stress testing because the horizons are much longer (decades vs. years) and the transmission channels are novel.

Two Risk Categories

1. Physical risk: Direct financial losses from climate events — floods, hurricanes, droughts, sea-level rise. These affect asset values (collateral damage), business revenues (supply chain disruption), and insurance costs.

1. Transition risk: Financial losses from the economic adjustment toward a low-carbon economy — carbon taxes, stranded assets (fossil fuel reserves that cannot be extracted), technology shifts, and changing consumer preferences.

Scenario Framework

Most regulators use scenarios aligned with the Network for Greening the Financial System (NGFS):

Example: Ridgeway Bank's Climate Stress Test

Ridgeway Bank has a $15 billion loan book with significant exposure to:

• Commercial real estate in coastal Florida ($2.1B)
• Oil and gas producers in the Permian Basin ($1.8B)
• Auto manufacturing ($900M)

Under the "Disorderly Transition" scenario:

Total projected credit losses under this scenario: $1.095B, compared to $320M under the orderly transition.

Key Methodological Challenges

• Long time horizons: Climate scenarios extend 30+ years, far beyond typical credit risk models (1-5 years). Banks must bridge the gap between long-term climate projections and standard credit risk parameters (PD, LGD).
• Data gaps: Historical data on climate-credit linkages is limited. Banks rely on expert judgment and proxy models.
• Non-linearity: Climate impacts have tipping points (permafrost melt, ice sheet collapse) that create sudden, large losses rather than gradual deterioration.
• Second-order effects: A drought in one region can disrupt global supply chains, affecting borrowers thousands of miles away.

Regulatory Landscape

The ECB, Bank of England, and Fed have all conducted or required climate stress tests. The trend is toward making these regular (annual or biennial) and incorporating results into supervisory assessments, though they do not yet directly determine capital requirements.

FRM exam tip: Know the distinction between physical and transition risk and be able to classify examples. Understand the NGFS scenario categories and why the time horizon challenge makes climate stress testing fundamentally different from cyclical macro stress tests.

For more on current issues in risk management, explore our FRM Part II course.