The management adage “What gets measured gets done” that Tom Peters popularized is playing out with European banks falling in step with regulatory pressure on tackling climate change.
A recent paper co-authored by Wharton accounting professor Luzi Hail, titled “Transparency and Real Effects of Climate Stress Tests for Banks,” shows how regulators’ mandated climate stress tests increased transparency at European banks in their reporting of climate risks and led to a reduced climate risk exposure in their loan portfolios. Next-order effects extended to the high-risk borrowers of those banks, which were forced to adjust their investment strategies.
Hail’s co-authors are three experts from the University of Mannheim in Germany — Jannis Bischof, chair of the business administration and accounting department, and doctoral students Vincent Giese and Gerrit von Zedlitz. They analyzed data from the 230 largest European banks from 2017 to 2022. These banks account for a large share of total lending in the European market.
“The stress tests could act as change agents for banks to become more aware of climate risks in their portfolios, and to integrate them into their financial risk management,” said Hail. “Ultimately, climate risks affect a borrower’s financial situation and are thus equivalent to the common credit risk.”
Regulators are using climate stress tests instead of imposing direct mandates to curb lending to high transition-risk borrowers, he noted. “With heightened awareness and better data, we expect incentivized banks to expand transparency, adjust lending standards, and reduce their loan exposure to climate risks,” the paper stated.
Not All Banks Are Equal
European banking regulators started to introduce climate stress tests from 2019 onwards, which required banks to methodically collect data and measure the climate risk in their lending portfolios. The study’s sample of 230 banks was made up of 55 banks that were subject to the climate stress tests, which formed the “treated group” in the analysis. These banks are typically the largest financial institutions in an economy. The remaining 175 banks served as the “control group.” The authors tracked changes in transparency about climate risks between the two groups both before and after the climate stress test mandate.
An increase in transparency was evident in just about half the 55 banks of the treated group. These were banks which already had a history of commitment to climate issues, such as having dedicated board committees for ESG issues, faced market-based pressure from outside investors and analysts to become climate-conscious, or were exposed to substantial climate risks in their portfolios.
“The stress tests could act as change agents for banks to become more aware of climate risks in their portfolios, and to integrate them into their financial risk management.”— Luzi Hail
A Climate Disclosure Score developed by the authors shows that after the stress tests, banks with such market-induced incentives — the paper referred to them as “committed banks” — increased their transparency by between 16% and 18% relative to the remaining banks. The effect translates into about six new disclosure items on their climate risk exposure and how they handle the climate risks in their lending portfolios.
But the effects did not stop with more transparency. Committed banks also actively managed their climate risk exposure and shifted their lending from long-term to short-term maturities for borrowers with high climate risks.
Constraints on High-Risk Borrowers
Next, the study focused on the stress-tested banks’ borrowers, totaling about 66,000 mostly private corporate clients, and analyzed their financing and investment strategies. Here, the paper tests regulators’ commonly held assertion that by forcing banks to be more transparent, the climate-risk policies would trickle down to bank borrowers and lead them to adjust their operations to a low-carbon economy.
The authors found that committed banks subject to climate stress tests — and only those — imposed funding and investment constraints on high-risk borrowers that faced significant risks in transitioning to low-carbon operations. Such high-risk corporate borrowers reduced their total and long-term loan financing, which in turn hampered their growth prospects and investment activities.
“We clearly see a link between banks being more conscientious about their lending to borrowers with high climate risks and these borrowers being constrained in their growth,” said Hail. “But we only find these effects for a small subset of banks that have good reasons to implement changes.” For the other banks, the study finds no evidence that they start more actively managing their climate risks in their lending portfolios. Rather, to the contrary, there are signs that these banks tried to gain business from their competitors.
One unintended outcome of the climate stress tests at committed banks could be that high-risk borrowers take their business to less committed and less tightly regulated banks, Hail said. Indeed, the study finds some evidence of such substitution taking place. “If anything, borrowers from exempted banks expand their long-term loan financing after the climate stress tests,” the paper stated. “Thus, the average borrower in the EU seems little affected by arguably stricter climate risk provisions for banks.”
Banks as Agents of Change
In the U.S., large banks with more than $10 billion in assets are required to conduct annual stress tests to check their ability to withstand recessions and severe economic downturns, but not climate stress tests. Hail did not expect U.S. regulators to mandate climate stress tests on banks anytime in the foreseeable future. The Securities and Exchange Commission in 2024 adopted rules to mandate “material climate risk disclosures” by public companies, but they have since been put on hold.
Nonetheless, Hail expects European regulators to continue their push towards more climate-friendly, but less intrusive, policies like climate stress tests. “European regulators, central bankers, and politicians see climate stress tests as one way to nudge corporations towards a less carbon intense, greener economy,” Hail said. “Ultimately, however, our study shows that whether such policies succeed heavily depends on what incentives are in place for these banks.”
