Climate stress test for the German banking sector: Impact of the green transition on corporate loan portfolios

We develop a novel stress testing framework to quantify the risks to the German banking sector from the green transition. Our methodology combines a macro-level and a micro-level approach to calculate scenario-dependent probabilities of default and losses. The macro approach leverages traditional stress testing techniques in which aggregate scenario variables are translated into aggregate estimates of credit risk indicators. The micro approach uses firm- level balance sheet and carbon emissions data, allowing for the projection of heterogeneous effects across individual borrowers. Given that climate-related risks impact individual sectors and borrowers of the economy differently, exploring ways to quantify the distribution of potential effects is a key element of our framework. We find that potential losses over the near term from a green transition are non-negligible, highlighting that banks' loan portfolios are vulnerable to climate policy. Our estimates show that there are large differences across sectors and firms depending on their characteristics, most notably their carbon footprint, highlighting the importance of concentration risk in bank portfolios.