Scenarios

Sergio Scandizzo and Tony Hughes

THE HOW AND WHY OF CLIMATE SCENARIOS

In setting out to test the robustness of the banking and insurance systems to climate change, regulators have exclusively called on scenario-based stress test methodologies. This approach, which was virtually unused prior to the 2008–2009 financial crisis, asks companies to infer the effects of a series of external macro trends on the financial performance of each bank’s activities.

In the context of routine stress testing for the purposes of capital adequacy assessment, this approach has been quite successful. The SCAP test, for example, conducted in 2009, was used to provide assurance to the market that prospective US-based counterparties were solvent, allowing interbank lending to resume at scale following the shock caused by the failure of a number of key market participants during the 2008–2009 financial crisis. Similar tests were adopted in various other jurisdictions.

The SCAP test itself was basic. In the space of a few short weeks, banks had to demonstrate that they were capable of withstanding a renewed macroeconomic stress scenario without exhausting their available capital reserves. Given the time available and the complexity of the