By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Frank Elderson said Wednesday that banks needed to build resilience against climate and nature shocks that could not be captured adequately by conventional risk models, as increasing uncertainty and non-linear effects made reliance on historical data less dependable.

Elderson, who is also vice chair of the ECB’s Supervisory Board, said in a keynote speech at an ECB-Bank of England conference that financial institutions had made substantial progress in identifying, quantifying and managing climate and nature risks, but that modelling could only address part of the challenge.

“The answer to unknown unknowns is therefore not just scenarios or risk modelling, but to build resilience against surprises,” he said.

“Resilience is not something we build after a disaster. Instead, it is something we invest in before shocks occur,” Elderson said.

Such resilience included sufficient capital, liquidity, operational capacity and strategic flexibility to absorb shocks that could not be predicted in advance, alongside risk management tools including underwriting, model overrides, risk appetite setting, portfolio steering and pricing, he said.

Elderson distinguished between risks that could already be identified and measured, risks whose existence was known but whose timing or magnitude remained uncertain, and what he called “unknown unknowns,” whose possible outcomes themselves could not yet be fully identified.

“We know that many of the C&N risks that matter most are, by their very nature, forward-looking,” he said. “And we know that because these risks are very different from past events, they are not fully understood and remain difficult to quantify.”

The future effects of climate change and nature degradation were by definition absent from the historical data used in traditional risk analysis, Elderson said, limiting the usefulness of backward-looking approaches.

Scenario analysis therefore remained essential for assessing potential vulnerabilities, but banks should not treat a limited range of scenarios as a sufficient basis for risk management, he said.

“Scenarios are a starting point, not an endpoint,” Elderson said.

“When facing uncertainty, we need to avoid a scenario ‘tunnel vision’ where risk identification and capital planning becomes anchored to a narrow set of scenario narratives,” he said.

Scenarios needed to be adapted to local circumstances and supplemented by expert judgment rather than treated as a compliance exercise, Elderson said.

“Scenarios must be applied, not just adopted. They must be challenged, not just run,” he said.

Many banks were still at a relatively early stage of incorporating climate and nature risks into their core risk models, Elderson said. Climate stress tests and scenario analysis covered all the risk drivers that banks themselves deemed material in only around 15% of cases, he said.

Banks therefore needed to understand the limits of their models and act early to reduce their exposure to risks that could become more severe over time, he said.

The ECB had nevertheless seen significant improvements in banks’ ability to assess climate and nature risks, including through better climate-hazard and geolocation data and increased use of public data sources, Elderson said.

Since 2022, however, the average share of interest income earned from carbon-intensive sectors by significant supervised banks had remained consistently above 70%, he said.

Elderson also pointed to evidence that some climate developments were occurring faster or more severely than previously expected.

The Arctic was warming at almost four times the global average and Europe at roughly twice the global rate, he said, while recent observations indicated that the Earth was accumulating heat more rapidly than many model simulations had anticipated.

Ocean heat had reached record levels, while ecosystems including coral reefs, forests and wetlands were losing resilience, potentially increasing the risk of cascading effects across ecological and economic systems, Elderson said.

“And repeated surprises on the upside should make us cautious about assuming that what remains unknown will be benign,” he said.

The supervisory lessons extended beyond climate and nature risks to other structural changes facing banks, including demographic shifts, artificial intelligence, geopolitical risks and quantum computing, Elderson said.

Rapid advances in artificial intelligence were already changing the cyber-risk landscape even though the eventual scale of the impact remained uncertain, he said.

Quantum computing also presented risks to cryptography because encrypted information could be collected today and stored until future technological advances made it possible to decrypt, he said.

“All of these macro trends could also have an impact on the sustainability of banks’ business models,” Elderson said. “They therefore all need an upscaled risk management framework, with scenario capabilities as a core pillar to help banks stay resilient and competitive over time.”

“For known knowns, our task is to measure. For known unknowns, our task is to prepare. And for unknown unknowns, our task is to build resilience,” he said.