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Opinion

What climate stress tests will tell us – and what they won’t

Investors must understand the limits of regulatory efforts to measure climate stress at banks.

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In academic circles, there is something distasteful about “teaching to the test”. To do so, the argument goes, is to approach education from the wrong perspective, one that prizes a result on paper at a single point in time over the kind of deep understanding of a subject that can only be properly assessed through more thoughtful, longer-term study.

In financial circles, there is sometimes a similar worry. The balance sheet stress tests that regulators implemented around the world in the wake of the global financial crisis more than a decade ago – and so often hailed as a sensible and practical answer to that meltdown – also have their critics.

That stress tests have made banking safer in one way is undeniable: banks are better able to withstand losses before they must call upon taxpayers to bail them out or regulators to resolve them in other ways. The solvency of the banking sector amid the coronavirus pandemic has even been held up as more evidence of its new resilience, even though a combination of extraordinary market interventions by central bankers and guarantees from governments has meant that this resilience has scarcely been tested.

Annual stress tests might be effective at showing what loan losses an institution can cope with. Where they are less effective – understandably, because they are not designed for this purpose – is in telling regulators, investors, clients and policymakers much about the way in which banks are deploying the capital that they have.

Investors, though, are frequently happy to rely on them, arguing that so long as banks are passing tests they are less likely to be subject to supervisory intervention – and so are a safer bet on that measure, if on no other.

Regulators around the world are beginning to roll out climate stress tests that seek to capture in vast spreadsheets a risk that is not new but is newly appreciated

So we come to the latest regulatory trend, catching as it does the concern of the moment for banks keen to parade their social utility: climate change. As we report this month, regulators around the world are beginning to roll out climate stress tests that seek to capture in vast spreadsheets a risk that is not new but is newly appreciated.

The language used is cautious. These tests are exploratory, pilot exercises, information gathering. They are designed to educate regulators and banks about risks and the challenges of responding to them. It all sounds very worthy.

But regulators are stuck in a bind. To avoid the charge of toothlessness, such tests must in time have concrete regulatory consequences. It seems inevitable that there will eventually be standards that banks will have to meet to show that they can deal with the kind of new risks that their business models – and those of their clients – are exposed to from both the physical impact of failing to respond to climate change and the transition impact of responding to it.

Doing so, however, will lay the tests open to the same charge made by those academics who would like to focus on building their students’ understanding – that success will demonstrate little beyond the ability to pass an exam.

The responsibility, therefore, will fall to investors. They must grasp the limits of what regulatory assessments can achieve, rather than rely on box-ticking in place of deep analysis and the kind of sustained pressure on behaviour that they are uniquely placed to apply.

Focusing on the best and the worst outputs of a test will change nothing. The mainstream is where the battle to respond to the global challenge of climate change will be won or lost.

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