Simplifying climate change adaptation for banks in the EU

This paper studies the effectiveness of risk management, one of the two channels identified by the Network for Greening the Financial System (NGFS, 2024) as those through which the financial system contributes to physical risk adaptation in the European Union (EU). We assess the efficacy of Level 3 prudential regulations in encouraging banks to include physical risk adaptation in their risk management and client engagement strategies. Our analysis adopts a broad perspective, encompassing not only prudential risk management but also, and in our view more importantly, prudential transparency regulation, given the positive leverage that stakeholders can exert to incentivise adaptation efforts. Our findings suggest that banks should consistently integrate physical risk adaptation into their stress tests, transition plans and Pillar III disclosures. Transition plans must address physical hazards, exposure and vulnerability and must set adaptation targets. Adaptation measures should be treated as risk mitigants reflected in losses given default (LGDs), with the severity and consistency of those losses being reflected in transition plans and stress tests. JEL Classification: K23, O52, Q54, Q58