The European Central Bank (ECB) announced today the launch of a supervisory climate risk stress test, aiming to assess banks’ preparedness for dealing with financial and economic shocks stemming from climate risk.

Described by the ECB as “a learning exercise for banks and supervisors alike,” the test is designed to identify vulnerabilities, best practices and challenges banks face when managing climate-related risk. The exercise will be conducted during the first half of 2022, with aggregate results expected to be published in July.

The launch of the new stress test follows the release last November by the ECB of the results of a comprehensive review into the European banking sector’s management of climate and environmental (C&E) risks, revealing major shortfalls in preparedness, with no banks meeting expectations, and many lacking sufficient improvement plans.

According to the ECB, the new stress test will target specific asset classes exposed to climate risk rather than banks’ overall balance sheets, with a focus on exposures and income sources that are most vulnerable to climate-related risk. The test will use scenarios based on scenarios prepared by Network of Central Banks and Supervisors for Greening the Financial System (NGFS), reflecting possible future climate policies, and will assess physical risks, including heat, drought and floods, and short and long-term risks stemming from the transition to a greener economy.

While the results of the stress test will not have a direct capital impact on banks, the ECB said that they will qualitatively inform the Supervisory Review and Evaluation Process (SREP), potentially indirectly impact Pillar 2 requirements through the SREP process.