Climate Reverse Stress Testing: Are You Ready?

We’ve spoken to many banks recently, and the message is clear: developing and implementing a climate reverse stress testing (RST) framework will be a significant challenge, particularly as it is a completely new regulatory expectation for climate risk from the PRA. Most banks are already familiar with RST in the context of credit, market, and liquidity risks. But extending this practice to climate introduces a different level of complexity.  

Until now, climate quantitative analysis has centered on standard stress testing and scenario analysis, asking what could happen under different climate pathways. Reverse stress testing flips the question: what climate pathway could push your business model to the point of failure?

You may have already fallen into the trap of believing these common myths; if so, it’s time to rethink your position: 

• “Our institution is not exposed to climate risk.” The PRA is unlikely to accept this - climate risk is systemic. It manifests as transition risk (such as carbon taxes or shifts in consumer expectations) and physical risk (both acute climate events and chronic changes). These drivers affect almost every portfolio: credit exposures like commercial loans and mortgages, market positions in bonds and equities, and even operational resilience. Hence, it is highly likely that your institution is already exposed to climate risk factors, directly or indirectly. 

• “Rain alone could never cause us to fail.” This could be true if it weren’t for the fact that risks don’t occur in isolation. Rainfall, carbon prices, GDP slowdown, and interest rate rises can interact in complex and non-linear ways to push an institution towards failure. Although a single risk factor might need to reach an extreme tail event to cause failure, multiple risk factors acting together don’t need to be extreme to push a firm to the brink. Plausible domino effects can occur - for example, in a mortgage portfolio, heavier rainfall increases flood risk, lowering property values and weakening collateral. At the same time, a rise in carbon prices lifts household energy bills, cutting disposable income and pushing up default probabilities. Higher PDs, combined with weaker collateral driving LGDs higher, can accelerate capital erosion towards the failure point.

• “The failure points are so extreme, there’s no benefit in analyzing them.” A failure point doesn’t have to mean the bank has collapsed entirely. In practice, it could be something completely plausible, such as the CET1 falling below 11% or liquidity buffers dropping under regulatory requirements. These are thresholds that banks already monitor as part of business-as-usual.  

• “What’s the benefit of RST? We already run standard stress tests.” RST forces firms to confront and explore extreme, and yet plausible, critical scenarios they might otherwise avoid. It can uncover vulnerabilities that remain hidden in conventional stress testing. 

We recommend that you should prepare for the following key challenges: 

• Defining failure points: Deciding exactly what a failure would look like is not straightforward and is the first challenge. Most firms will base the breaking point on a regulatory capital measure such as CET1. From there, they need to identify the internal drivers (PD, LGD, credit spreads, liquidity buffers etc) that would cause it to erode. 

• Deriving transmission channels: The next critical step is mapping which climate variables (such as carbon price, rainfall, and temperature shocks) could realistically impact those internal drivers. For example, in mortgage portfolios, heavier rainfall could reduce property values and raise insurance costs, leading not only to higher LGDs but also higher PDs. 

• Developing supporting models: In many cases, deriving the relationships between the different drivers requires additional supporting models. For example, firms may need to develop models to measure and assess the relationship between rainfall and LGD/PD. 

• Quantification of the narrative: Over time, the PRA is likely to require qualitative insights to evolve into quantified relationships between climate drivers, bank risk factors, and failure points. It’s not just about establishing a link between rainfall or carbon prices and LGD/PD, but defining potential levels of the risk factors that could push the bank to failure.

• Embedding outcomes: RST results need to feed into firm-wide processes and systems, including governance, reporting, and ongoing monitoring. At this stage, RST stops being just a regulatory expectation and becomes a proactive tool for managing risk. 

At Zanders, we can support you in developing climate RST frameworks that are: 

• Proportionate: from plausible qualitative narratives to quantification models, aligned to your portfolio exposure to climate risk. 

• Scalable: solutions that evolve along with your firm’s climate risk journey. 

• Strategic: we guide you through achieving regulatory compliance while always keeping an eye on your long-term business objectives. 

How far are you with planning and self-assessment for climate RST at your firm? Our advice: don’t wait until the updated Supervisory Statement is published by the PRA to planning (or start putting in place a plan for) for a climate RST framework. Starting early will make the process smoother and ensure you are well-positioned and prepared when regulatory scrutiny will inevitably materialize. 

We would be delighted to share our insights and discuss how we can support your climate risk journey. Please reach out to the Zanders UK climate risk modeling team (Polly Wong, Nikolas Kontogiannis, Hardial Kalsi, Paolo Vareschi).