Banks are the backbone of many industries, and if banks encounter problems, it will undoubtedly have an impact on the economy. In the past two to three years, central banks and regulatory authorities around the world have begun to require banks to conduct stress tests related to climate change in order to understand the impact of global warming on banking operations. So far, the European Central Bank (ECB) has conducted the most detailed tests, using both macro and micro analyses and providing forecasts of bad debt rates under different scenarios, such as short-term climate deterioration and long-term climate change.
The ECB emphasizes that the impact of global warming on the economy is exceptionally complex and that there are no previous data to reference. This test is just part of the learning process, and the ECB will not adjust the capital requirements for banks based on the test results.
Limited Estimated Impact
The impact of global warming on the quality of bank assets mainly includes two aspects. First, there is physical risk – the impact of crises caused by global warming, such as floods, rising sea levels, or wildfires, on bank customers or the bank’s own operations and assets. Second, there is transitional risk – the impact of policy changes or new technologies on borrowers’ repayment abilities. A typical example is the reduced carbon emissions and its impact on a company’s economic performance.
From the macro test conducted by the ECB, it can be seen that southern European countries have relatively higher physical risks. Nearly all commercial loans in Greek banks can be categorized as high physical risk, and the same goes for Cyprus, where the proportion is as high as 75%.
As for transitional risks, they are less related to geographical location. About 40% of commercial loans from banks within the European Union come from high carbon-emitting industries, with most of it coming from large banks. Because many high-emission loan projects come from large companies in industries such as oil, mining, or energy supply, small banks simply do not have the capacity to make such large loans.
As for how global warming affects the quality of bank loans, the micro test conducted by the ECB can be used as a reference. The test includes two scenarios: long-term climate change and short-term climate deterioration. Even under the assumption of the worst long-term climate change, bad debt rates only increase by roughly 0.2% per decade between 2040 and 2050. The ECB has not disclosed the impact of the increase in bad debt rates on bank profits. However, a rough estimate indicates an impact of only a low single-digit percentage on their annual profits, which is not too high. If there is a severe short-term climate deterioration, the test estimates a potential increase of 70 billion euros in bad debts. While this result is much higher than the losses caused by long-term climate change, it still seems to be less than one year’s profit for European banks and should not significantly erode bank capital.
Global Warming is Different from Past Natural Disasters
The Hong Kong Monetary Authority has also conducted similar tests. For instance, in the scenario of short-term climate deterioration, mortgage bad debts for residential properties would reach HKD 17.3 billion by 2050, a 25-fold increase from HKD 700 million in the fourth quarter of 2020. The profits of Hong Kong banks before making provisions for bad debts last year were approximately HKD 170 billion. From this, it can be seen that the impact of global warming on Hong Kong bank capital seems manageable at the moment.
The Federal Reserve Bank of New York (NY Fed) pointed out in a research report last year that natural disasters could even benefit the banking industry. This is because part of the cost of post-disaster reconstruction comes from bank loans. However, investors should be aware that global warming is not a one-time short-term disaster but a year-after-year, continuous, repeating, and worsening process. Therefore, it is believed to be fundamentally different in nature from past disasters.
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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