Banks unprepared for climate shocks, ECB urges tougher supervision and swift policies

The European Central Bank, in collaboration with the European Systemic Risk Board and research institutes across the euro area, has sounded the alarm over the resilience of Europe’s banking sector in the face of accelerating climate risks. Published in September 2024, the ECB’s working paper deploys stress-testing models and granular bank-level data to explore how financial institutions would withstand sudden climate shocks. The conclusion is unsettling: while climate change is already reshaping economies, banks are not adequately prepared to absorb the shocks from either policy-driven transitions or intensifying natural disasters.

Transition Scenarios Reveal Uneven Dangers

At the core of the report are scenario-based stress tests that lay bare the trade-offs between early and delayed policy action. A “delayed transition” scenario, in which governments postpone decisive measures until political and environmental pressures make them unavoidable, produces the harshest consequences. Carbon prices surge abruptly, the value of fossil fuel-linked assets plummets, and banks are forced to absorb severe losses. By contrast, a disorderly but earlier transition spreads costs over time, offering institutions space to adapt, though profitability and credit supply still suffer. The study makes clear that no pathway is free of financial strain, but that postponement significantly magnifies the risks.

Carbon-Intensive Portfolios in the Spotlight

The research highlights how banks with large exposures to carbon-heavy sectors are especially vulnerable. Lenders tied to oil, gas, coal, and heavy manufacturing could see defaults rise sharply as these industries struggle under higher carbon prices and tightening regulation. Charts in the report reveal a striking regional disparity. German and Italian banks, heavily exposed to energy-intensive manufacturing, appear particularly at risk, while larger international banks are somewhat shielded by diversified portfolios. Smaller and regionally concentrated lenders, however, remain closely linked to local industries with few alternatives, leaving them most exposed to sudden shocks. The unevenness of this exposure suggests that climate policy could trigger localised financial instability even if the broader system remains intact.

Physical Risks Add a New Layer of Fragility

Beyond the transition risks lie the physical risks of climate change, which the report warns could be just as damaging. Extreme weather events, heatwaves, floods, droughts, have the potential to reduce collateral values, disrupt business continuity, and increase insurance costs. In agricultural economies and regions already grappling with water scarcity, farmland and property values could decline dramatically, impairing banks’ ability to recover losses from defaulting borrowers. Visual evidence presented in the paper paints a vivid picture: collateral tied to climate-sensitive assets, especially in southern Europe, may erode sharply as climate impacts intensify, feeding directly into higher levels of non-performing loans.

The Data Deficit and Policy Imperative

Perhaps the most urgent concern raised is the data gap that blinds banks to their full climate exposure. Many institutions lack reliable information on emissions, energy usage, and sectoral vulnerabilities in their loan books, making it difficult to conduct meaningful risk assessments. This absence of standardized, granular data could itself become a source of systemic risk, delaying corrective actions until financial losses become unavoidable. To close this gap, the ECB calls for more stringent disclosure requirements and harmonized reporting standards. Supervisors, the report suggests, must integrate climate risks into their regular oversight, from capital buffers to mandatory stress-testing exercises. At the same time, the study stresses that banks cannot face this alone. Governments must act decisively to manage the low-carbon transition in an orderly manner, providing a predictable policy environment that limits shocks to the financial system.

A Systemic Challenge Demanding Urgent Action

The overall message is unambiguous: climate change represents not only an environmental or political challenge but also a profound financial stability risk. Delayed action will trigger sharper, destabilizing adjustments that could reverberate through the banking sector and beyond, while early, coordinated measures, though costly, offer a more manageable path. The ECB and its research partners insist that the time for preparation is running short. With climate impacts already pressing on Europe’s economies, the resilience of banks will depend on the rapid development of better data, stronger supervisory frameworks, and above all, timely policy coordination that prevents today’s manageable risks from spiraling into tomorrow’s systemic crisis.