The European Central Bank is updating its collateral framework to include new climate factors. This collateral framework determines how much banks can borrow from the ECB when using corporate bonds as collateral. This mitigates systemic risks in EU markets because improperly valued collateral could leave the ECB exposed if banks default on their loans. To that end, the ECB considers climate exposure to be a major risk, and by including it in their framework they hope to avoid overvaluing collateral that is risk-exposed. The ECB quantifies this risk in three categories: stressors, exposure, and vulnerability, defining each as follows in their press release:
“The stressor component captures the potential impact of a transition shock on financial asset values for different sectors; for example, a shock would likely have a stronger financial impact on the carbon intensive utility sector than on the software and services sector. Compared with a baseline scenario without such a shock, the stressor measures how asset values decrease at the sector level and can be understood as a common ‘market factor’ applied to all firms in the same sector.
Exposure is assessed at firm level, using information on greenhouse gas emissions, decarbonisation targets and the quality of climate-related disclosures. Within the same sector, firms differ in how well they are aligned with the transition to a low-carbon economy. The exposure component therefore measures how sensitive an individual firm is to sector-level shocks.
Vulnerability is assessed at asset level and is represented by the square root of the asset’s residual maturity. Longer‑dated securities are treated as more vulnerable to shocks because a larger share of their cash flows is exposed to future transition developments.”
Climate-related risks are increasingly manifesting in the market. As the effects of climate change continue to drive risk, more financial institutions and governments will begin pricing that exposure into their lending practices.
Our members can learn more about sustainability in the financial services sector here.
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