| Heightened flood risk could leave homeowners unable to remortgage their properties and could contribute to increased loan losses at banks. Source: Christopher Furlong/Staff, Getty Images News via Getty Images Europe. |
The transition to a low carbon economy could drive mortgage impairments up between 40% and 164% for the U.K. banking sector, and even higher if no transition takes place at all, the BoE's 2021 Climate Biennial Exploratory Scenario found.
Of the banks that took part in the climate stress test, Nationwide Building Society and the U.K. branch of Banco Santander SA currently have the largest mortgage exposures as a percentage of their total lending book, at 95.2% and 84.7%, respectively. They are followed by Lloyds Banking Group PLC at 68.3%, according to S&P Global Market Intelligence data.
The exercise also looked at HSBC Holdings PLC, Barclays PLC, NatWest Group PLC and Standard Chartered PLC. The banks represent about 70% of U.K. bank lending.
The seven were assessed under three stress scenarios toward 2050: early, late or no additional action against climate change.
On aggregate, the lenders forecast a 40% increase in mortgage losses in the early action scenario and 164% under the late action path over the 30-year assessment period. The green transition will cost British households an aggregate of £75 billion for improving the energy efficiency of their homes, a liability that will affect borrowers' ability to afford mortgage repayments and translate into additional impairments for banks, the BoE said.
Both scenarios assume that policies are implemented to drive the transition to a net-zero economy by 2050, but in the late action scenario these efforts are postponed by a decade. Such a delay will cause rising unemployment, falling house prices and a general macroeconomic downturn, which will put further stress on mortgage borrowers and drive a substantial additional increase in mortgage losses, the BoE found.
The U.K. mortgage market would face an even more severe hit in the event of no energy transition. Under the most severe climate change scenario, which assumes no additional policy measures are adopted to reduce global warming, banks projected a 170% increase in mortgage losses, driven by an intensification of physical risks, in particular in areas most heavily impacted by flooding. Flood risks would cause housing values to drop and/or make homes uninsurable, making it difficult for households to remortgage their properties, the regulator said.
Mitigating actions
A spokesperson for Santander UK noted that the climate stress test assumed a static balance sheet, which may affect projected losses.
A static balance sheet approach means the scenarios were tested on banks' 2020-end balance sheets, which are assumed to be fixed in size and composition. As such, it does not take into account any developments and changes over the next three decades, including management action to mitigate the risks, which analysts have deemed unrealistic.
Nationwide, meanwhile, said its assessment of the scenarios within the exercise indicates that "climate risk does not present a threat" to its current business model. The lender has in place controls to help limit its exposure to physical risks, and the impact of transition risk is, in part, dependent on government policy and regulation, a spokesperson for the building society said.
Nationwide is working to set science-based targets to achieve net-zero by 2050, which will help reduce its transition risk, according to the spokesperson.
Lloyds Bank, the U.K.'s largest mortgage lender, did not respond to a request for comment. In its latest sustainability report it said it would leverage the learnings from the Bank of England's exercise to undertake further climate scenario analysis and help it understand the resilience of its business model to climate risk. This will help support the development of new business plans and sector ambitions, Lloyds said, adding that it will report decarbonization targets for carbon-intensive portfolios such as residential mortgages in 2022.
Affordable risk
The stress-test findings will force management at institutions with "monoline business models," in particular those with the highest exposure to the U.K. real estate sector, to "begin to consider business model climate vulnerabilities more closely," said Fitch Ratings in a May 20 note.
Banks with large mortgage books "obviously have some risk to manage and work through," including adapting their modeling and pricing to the risk, according to Will Edwards, credit analyst at S&P Global Ratings. But, Edwards said, banks that took part in the exercise have the capacity to absorb rising losses should any of the scenarios play out.
"It's still very affordable risk," Edwards said, adding that any increases in mortgage losses would be from "a very low base." The credit rating agency forecasts residential mortgage losses for U.K. banks to land between 0 basis points and 5 bps in 2022 and 2023, the analyst said.
Corporate exposure
Even if banks reported relatively higher loss increases on their mortgage book in the BoE exercise, these exposures are likely to be less risky than other portfolios due to the availability of data in this segment, said Pauline Lambert, executive director of financial institutions ratings at Scope Ratings. Banks have relatively solid information on their mortgage customers, for example on houses' energy efficiency, as well as models to forecast exposure to flood risk, making lenders better placed to assess and control both transition and physical risk in their mortgage book, Lambert said.
In the corporate lending portfolio, in comparison, banks face much larger data gaps, meaning it will be more challenging for them to accurately quantify the risk of individual customers, exposing lenders to potentially higher unknown climate risk, Lambert said.
Illustrating issues around data, financial institutions in the stress test projected "substantially different loss rates" on shared corporate counterparties, with the highest estimates typically being around twice as large as the lowest across scenarios, according to the BoE. This was driven in part by differences in banks' views on how successfully these clients would be able to implement their transition plans.
In aggregate, corporate losses increased by between 95% and 100% in the two transition scenarios of the stress test, most of which were concentrated in mining, manufacturing, transport and wholesale and retail trade, according to the BoE.
In the no additional action scenario, the BoE even made an illustrative adjustment of banks' reported loan loss figures, raising it to 95% from 35%, to account for data gaps in the modeling of corporate losses.
