ECB Urges Banks To Fully Integrate Climate Risks

The European Central Bank (ECB) has indicated that banks in the euro area have made significant improvement in managing climate and environmental (C&E) risks, which is a significant turnaround from several years ago. Over 90% of banks now identify material exposure to these risks, up from only 50% in 2021. However, while improvement is underway, the ECB warns that certain key gaps persist, especially in the integration of physical climate risk and nature-related risks into capital planning and risk assessment.

Frank Elderson, Vice-Chairman of the ECB Supervisory Board, recognized the efforts of the industry to the extent that the banking sector has come a long way because of efforts laid by risk experts on climate, internal auditors, and risk managers. He stated that fewer than one-quarter of euro area banks in 2019 had addressed how global warming and loss of biodiversity had affected their risk profile. That figure has been high as the institutions have been competing to meet supervisory expectations.

Nonetheless, Elderson warned best practice is still unevenly applied. While there are banks that have added transition risks of the type—policy and market change due to decarbonization—into some processes like collateral valuation, they exclude physical risks such as floods, heatwaves, and wildfires. Additionally, C&E risks are more integrated into credit risk models than operational or market risk models.

To enforce compliance and facilitate banks' climate resilience, the ECB employed an assertive supervisory approach. Based on its 2022 climate risk stress test and thematic review, the central bank provided a road map of expectations for banks. Banks were required to conduct in-depth materiality tests by March 2023. The ECB made 28 binding decisions to impose this, out of which 22 contained potential recurrent penalty payments for non-compliance.

By the fourth quarter of 2023, banks have been required to integrate climate-related risks into their rule-making and broader risk management systems. Although the majority of banks reached this goal, nine banks received additional binding decisions for failing to do so. The second key milestone is by the end of 2024, where banks are required to integrate C&E risks in entirety into their internal capital adequacy assessment processes (ICAAPs) and stress tests. Initial feedback is promising, if not yet widespread, says Elderson.

There has been an advancement, but there remain significant gaps. Although 100% of euro area banks currently incorporate climate risks in their stress-testing models, from just 41% in 2022, many exclude too few of the material risk drivers from scope. Transmission channels and compounding high-impact events, such as extreme weather with economic downturns, are poorly captured. Moreover, environmental risks are still underestimated in capital planning. It was mentioned by Elderson that 75% of banks have not included all climate and nature risk drivers they should in their ICAAPs and only one-third of them explicitly include these risks in their capital plans.

These flaws can result in the underestimation of systemic risk of exposure, especially with increasing acceleration in the process of climate change. Elderson referred to some examples of increasing physical climate risks, i.e., Valencia's disastrous flooding, widespread heatwaves in Europe, and blazes south of Marseille. Insurers like Allianz and Swiss Re have already warned that increasing climate losses may ultimately make parts of the insurance business economically unsustainable—resulting in a systemic danger to the financial system.

The ECB also stressed the need for high-quality data and disclosures to enable proper supervision and market discipline. Elderson warned that recent attempts to streamline the EU sustainable finance reporting template are at risk of going too far. Specifically, leaving out medium-large companies with 500-1,000 employees from the Corporate Sustainability Reporting Directive (CSRD) may cause important data gaps. The ECB would like to impose proportionate reporting requirements on such firms to guarantee the validity of climate risk assessments.

As developments continue, the ECB is gearing up for the second phase of climate supervision. Banks in the euro area should be subject to new prudential transition preparation requirements by 2026. All the features are already entrenched in current supervisory requirements. Between 2025 and 2026, the ECB will discuss the progress with banks in an informal manner to track progress, identify implementation issues, and provide advice. From 2027, the ECB will conduct formal reviews. Where there are still significant gaps—particularly regarding comprehensiveness or geographic coverage—Joint Supervisory Teams will step in.

In addition to backing the banking sector, the ECB will release an updated compendium of good practices towards the end of 2025. The report will summarise lessons learned from stress tests, thematic reviews, and supervisory guidance. The ECB will also organize an industry outreach conference on 1 October 2025 to exchange findings, facilitate debate, and foster consistent improvement in climate and nature risk embedding.

Elderson ended his speech with a resounding message: climate and environmental risks are not just a regulatory imperative but a condition of long-term financial health. "With systemic nature and climate risks looming, only resilient banks are in a position to lend to pay for the green, digital and defence transitions we must save our way of life," he said.