In December 2021, the Hong Kong Monetary Authority (HKMA) issued the results of its pilot climate risk stress test (CRST).  The CRST assesses the potential impact of climate change on the Hong Kong banking sector.  It marks the latest such publication by a regulator on the topic, with French regulator, Autorité de contrôle prudentiel et de résolution (ACPR), having published the results of its climate risk stress test in Q2 2021 and a number of other countries’ regulators undertaking similar analyses during 2022.

The CRST indicates that the Hong Kong banking sector should remain resilient to climate-related shocks given the Banks’ strong capital buffers. However, it was noted that simplified assumptions and use of historical data in modelling could mean the potential impact could be more serious than predicted.

The exercise identified various climate-related vulnerabilities for Banks to seek to address and highlighted gaps in terms of insufficient granular, reliable data, as well as a lack of widely-accepted standards for classifying and identifying climate risk exposures.  HKMA notes that addressing these issues will require concerted efforts of the industry.

In this Blog Post, we set out a high level summary of the CRST in terms of the scope of the CRST, pertinent findings and actions required to enhance climate risk management going forward.

Scope

The CRST involved 27 banks from the Hong Kong banking sector accounting for 80% of the sector’s total lending (the Banks).

Its principal objectives were to: (i) assess the overall climate resilience of the banking industry; and (ii) build capability with respect to climate risk management.

Climate risks were assessed against three scenarios:

  • Physical risk scenario of worsening climate, based on increased temperature and sea levels (as at 2051 to 2060); and
  • Two transition risk scenarios concerning implementation of policies to achieve the Paris Agreement climate goals in: (i) an orderly transition – assuming early and progressive actions over a 30 year period (2021 and 2050); and (ii) a disorderly transition – assuming abrupt changes over a five year period (2031 to 2035).
Pertinent findings

Physical risk findings

  • Banks considered that 32% of their Hong Kong property-related lending is pledged against collateral in climate-vulnerable areas and the devaluation of such property could be more than 50%.
  • Total expected credit losses (ECLs) were estimated at three times more than in Q4 2020, and 1-year ECLs of residential mortgages were expected to rise 25-fold (HK$0.7bn to HK$17.3bn).
  • Banks also assessed operational losses, projecting a 0.8% (HK$ 2.2 billion) annual operating loss, but considered adoption of technology solutions and flexible working arrangements as a result of COVID-19 have assisted to mitigate such losses.

Transition risk findings

  • The CRST found that for both transition risk scenarios, risk would typically manifest through increased credit exposures but that this was particularly the case with the disorderly transition scenario.
  • Higher credit cost, with an increase in credit risk-weighted assets, would lead to a ‘notable deterioration’ in the Banks’ capital position. For the domestic systemically important authorized institutions (D-SIBs), the capital adequacy ratios were estimated on average to drop by three percentage points over the five year period.
Looking ahead

Banks

In addition to reporting the CRST findings to senior management and submitting plans to HKMA to address the vulnerabilities identified by the exercise, the Banks have undertaken to keep abreast of market developments and ensure continuous efforts to enhance capabilities for climate risk management.

Some of the Banks have also devised plans for allocation of resources to climate resilient activities and establishing mechanisms to incorporate a broader range of climate risk factors and key metrics into their climate risk management framework.

HKMA

The HKMA will continue to engage the industry to support the sector’s capability building to manage climate risks. In particular, the HKMA intends to:

  • reach out to the industry to share the lessons learnt from the CRST and provide guidance to help banks strengthen their capabilities to meet supervisory expectations on managing climate risk;
  • explore possible solutions to resolve challenges, especially those that require concerted efforts of banks to improve the climate resilience of the industry as a whole;
  • collect the industry’s feedback and enhance the scenario specifications and develop the climate related stress test framework; and
  • explore opportunities to collaborate with overseas authorities to promote greater consistency in climate related stress test practices.

Given the high concentration of global banks in Hong Kong, the HKMA further reminded the industry to work on developing solutions and models to assess climate risks that take into account the variations in home-host regulatory requirements, as well as the differences in the business models of the banks in various markets.

HKMA intends to undertake a second climate related stress test in two years’ time.

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