Major financial institutions will have to answer for how well prepared they are for climate change, as the prudential regulator reshapes its stress testing framework.
APRA has made the call after releasing its findings from a stress testing review across 28 authorised deposit-taking institutions (ADIs).
The regulator conducted the assessment of internal stress testing during 2018 to 2019, focusing on governance, scenario development and use of stress testing within institutions.
In a letter to industry, APRA has said it identified a number of areas needing “ongoing improvement” and its findings will inform further development of its guidance for the banks.
ADIs will need to prepare to move towards greater frequency and depth of stress testing, with APRA hinting at annual stress testing of large ADIs.
The regulator added that it will be testing resilience across “broader scenarios, including the impacts from operational and climate change financial risks”.
The larger diversified ADIs which were examined in the review included the big four, AMP, Bank of Queensland, Bendigo Bank, HSBC, ING, Macquarie, Suncorp and Citi. Meanwhile the smaller ADIs, with total assets in the range of $3 billion to $25 billion included players such as Heritage Bank and MyState.
APRA has urged banks across the board to have “better coverage of non-financial and emerging risks” for scenario development.
Emma Herd, chief executive officer of the Investor Group on Climate Change (IGCC) weighed in, as the federal opposition committed to a net-zero emission target for 2050.
“We are seeing an increasing consensus among investors and the business community that a 2050 net-zero emissions target constitutes the responsible economic management needed to address systemic climate change risk,” Ms Herd said.
“Other important financial regulators like the Reserve Bank and ASIC have also recognised that climate change presents a material risk to our economic prosperity.
“Meeting the goals of the Paris Agreement will significantly de-risk the Australian economy by guarding against the ratcheting physical and financial impacts of climate change such as worsening extreme weather, rising insurance premiums and the prospect of stranded assets.”
A recent report from the IGCC showed that many long-term investors are already factoring in climate change risks and net-zero emissions scenarios into their investment decisions and in their engagement with listed companies. The group anticipates the industry trend to continue.
Banks are supposed to engage in stress testing as part of their risk management, to help enhance their readiness to withstand adversity by “improving their understanding of risk, boosting capital management, informing recovery planning and reducing the likelihood of failure and resolution”, ARPA’s letter read.
Larger ADIs were said to generally make better use of stress test results and use the process in a wider range of decision making than smaller firms, but the coverage and level of detail would vary across the group.
For the smaller ADIs, the role of stress testing would appear much less prominent, where results were said to be used for the validation of their main internal capital targets. APRA added they “typically did not have well-defined risk appetites around their capital adequacy”.
Many participants in the review were said to use previous APRA industry test scenarios either as a substitute for their own internal capital adequacy assessment processes (ICAAP) scenarios, or as a reference to inform the macroeconomic settings of their own internal scenarios.
Scenario development in smaller ADIs was also noted to be generally less structured and integrated than in larger institutions.
While many of the larger diversified ADIs were said to have formalised governance structures with clear roles and accountabilities, their frameworks were said to not always be subject to regular independent reviews.
Meanwhile, smaller banks and credit unions were reported to not have specific stress testing frameworks, instead relying on risk-specific management frameworks and ICAAP documentation.
APRA indicated it will be publishing a prudential practice guide on stress testing, as well as consulting with industry in the second half of the year.
Sarah Simpkins is a journalist at Momentum Media, reporting primarily on banking, financial services and wealth.
Prior to joining the team in 2018, Sarah worked in trade media and produced stories for a current affairs program on community radio.
You can contact her on [email protected].