Building financial resilience: Five developments shaping EU stress testing

Financial institutions are facing an evolving set of risks. Climate change and nature-related risks are becoming increasingly macro critical and regulators are starting to mandate climate stress tests and push nature risk up the supervisory agenda. In effect, climate and environmental stress tests are moving from exploratory towards becoming a core part of banks capital adequacy process.

As these regulatory expectations develop, banks are expected to demonstrate not only the severity of their scenarios, but also how those scenarios translate consistently from macroeconomic assumptions through to sector performance, portfolio impacts and capital planning.

During our recent webinar, we explored five developments that are shaping stress testing across Europe and what this means for financial institutions. This article brings together the key insights.

If you would like to explore these topics in more detail, you can watch the webinar on demand, Meeting EU Stress Testing Requirements: Macro, Climate and Nature Risk.  

1. Build a more integrated view of risk

Historically, macroeconomic stress testing, climate scenario analysis and environmental risk assessments have been conducted as separate exercises using different assumptions, datasets and methodologies.

That approach is becoming increasingly difficult to justify.

Our baseline forecast at Oxford Economics now embeds our view on both forward-looking transition and physical climate risks across the global economy. Whilst regulators are moving towards integrated frameworks that consider how macroeconomic conditions, climate and nature risks interact within a single scenario. Rather than viewing these risks independently, firms are expected to understand how shocks cascade through the economy, financial system and wider environment in both central scenarios and adverse stress-tests.

The objective is a realistic and holistic view, one that reflects the interdependence of the economy, environment and financial system. Rather than respond to individual threats in isolation, banks can better manage how interconnected risks affect their portfolios, operations and strategic decision within the same risk management function. 

2. Connect every scenario to real business impacts

Creating severe but plausible scenarios is no longer enough.

Supervisors increasingly expect institutions to demonstrate how a scenario evolves from the initial macroeconomic shock through to its effects on sectors, borrowers and portfolios. Every assumption, from GDP growth and inflation to interest rates, sector output and asset prices, needs to be internally consistent and credible.

Traceability is becoming just as important as the scenario itself. It allows regulators, validation teams and senior management to understand the results and the transmission mechanisms that produced them. For example, understanding the chain of events from the rise of carbon prices to higher inflation to interest rate decisions.

For banks, that means moving to a single, coherent framework that can explain how global shocks propagate across countries, sectors and portfolios. Models such as Oxford Economics’ Global Economic Model are designed with this in mind, providing a consistent, integrated and transparent structure with easy-to-understand transmission channels from economic risk to macroeconomic and sector-level impacts.

3. Treat climate risk as core to business strategy

Climate risk is no longer treated as a separate ESG exercise.

Supervisors increasingly expect both transition and physical climate risks to feed directly into core credit risk models, influencing probability of default (PD), loss given default (LGD), expected losses and ultimately capital planning.

Institutions need to demonstrate how transition policies, carbon pricing, extreme weather events and chronic climate change affect inflation, interest rates, productivity, sector performance and borrower resilience within the same macroeconomic scenario. 

Physical climate risk is becoming particularly important too. Acute events such as floods, storms and heatwaves cause immediate disruption to businesses and collateral values, while gradual chronic changes, including rising temperatures and water stress, steadily erode productivity and long-term economic growth.

These outputs can then be integrated into credit risk models, translating physical hazards into tractable, decision-ready financial impacts. Institutions can move beyond measuring exposure to understanding how those risks affect resilience across lending portfolios, capital adequacy and long-term business planning.

4. Understand risk where it really sits

Headline GDP forecasts are no longer sufficient, and more granularity is the direction of travel.

Banks increasingly need to understand how individual sectors respond under stress and how those impacts vary across regions and supply chains.

Granularity across these dimensions is becoming increasingly important as EU reporting requirements evolve and firms seek identify mitigation measures and strategies before disruption occurs rather than responding after events. It enables institutions to identify with precision whether losses are driven by sector exposure, geographic concentration or wider macroeconomic conditions.

Producing this level of insight requires robust sector level data and consistent mapping between counterparties, industries and regulatory reporting classifications, an area that continues to grow in importance as reporting standards become more detailed and precise. Our clients are now able to observe how sectors such as construction, agriculture, manufacturing, utilities and transport all face different vulnerabilities to both transition and physical climate risks.

5. Prepare for nature-related risks

Alongside climate, nature-related risks are rapidly climbing the supervisory agenda.

Many sectors depend heavily on ecosystem services such as water supply, soil quality regulation services, biomass provisioning and pollination, amongst a host of others. As natural systems deteriorate, physical nature-related risks are on the rise, with the economic impacts focussed on primary sectors but also extending well beyond agriculture, affecting manufacturing, construction, utilities, food and food production via supply chains.

Sectors also have an impact on nature, including through using land, water and emitting a range of pollutants and waste. Leading to vulnerabilities as policymakers and society seeks to address the issue of nature loss. Land-use restrictions, pollution taxes, water quotas and recycling mandates are just some of the transition risks portfolios are exposed to.

Supervisors are therefore increasingly encouraging firms to assess both the direct and indirect nature dependencies and impacts within their portfolios. While methodologies are still evolving, there are sufficient data and tools to get started. Nature stress testing starts with a screening and materiality tests to identify the main drivers of risk and most use geospatial data on the ‘state of nature’ and ecosystem condition to reflect the reality on-the-ground. Whilst this is novel and challenging, there are commonalities with climate stress testing to draw upon. Nature risk is becoming a material driver of financial risk that institutions can no longer ignore.

From compliance to resilience

The direction of travel is becoming increasingly clear. Regulators are asking institutions to move beyond producing individual stress testing exercises towards integrated, transparent and decision ready frameworks with an enhanced focus on climate and wider nature-related risks.

For example, under the EBA’s draft EU-wide stress test for 2027, which will be mandated for the largest financial institutions, transition and physical climate risk should be incorporated in the exercise as simultaneous shocks alongside the core macro-financial shocks in the exercise. Meanwhile, all EU banks, under the EBA’s guidelines on environmental scenario analysis, are expected to conduct climate and nature-related scenarios on the most material risks their institution faces.

Oxford Economics can help banks large, medium or small prepare for what’s next. Our Global Economic Model (GEM) links macroeconomic conditions, sector dynamics, climate transition, physical climate impacts and nature-related risks within a single, consistent modelling framework. Organisations can better anticipate disruption, quantify vulnerabilities and understand how shocks propagate through the environment, sectors, supply chains, economies and portfolios. This helps meet supervisory expectations and supports better decisions around capital allocation, risk management and long-term strategy.

Ultimately, this evolution is about moving beyond compliance to building resilience in a world of increasing correlated and uncertain risks.