Regulatory Alerts2025-12-26 | FSD Circular No. 01Guidelines on Climate Stress Testing 2025
The State Bank of Pakistan has introduced mandatory climate stress testing guidelines for financial institutions, encompassing physical risk scenarios like floods and transition risks such as carbon tax impacts. These institutions must assess their capital adequacy and liquidity positions using standardized historical flood data and sectoral vulnerability scores while also reporting results regularly to their Risk Management Committees. Furthermore, Domestic Systemically Important Banks are required to incorporate these climate-related risks into their broader macro stress testing and scenario analysis exercises to ensure long-term financial stability.
Guidelines on Climate Stress Testing 2025
1. Introduction
State Bank of Pakistan (SBP) issued its first detailed guidelines on Stress Testing (ST) in 2005, which were revised in 2012 and further updated in 2020 to account for the developments in global supervisory practices, availability of new techniques and changes in local banking business and regulations.
2. Importance of Climate Change
Climate change and its related risks have emerged as the leading global challenge for economic and financial stability, with dire implications for the welfare of affected communities and parties. Measuring the adverse impacts on the performance and stability of the financial sector has become crucial. Climate-related risks, specifically physical and transition risks, can transmit to traditional banking risks including credit, market, liquidity, and operational risks.
5.1 Physical Risk Analysis for Banks, DFIs and MFBs
The scope of this exercise extends to the lending portfolio of banks (including Islamic banking operations of conventional banks), DFIs and MFBs. Five shocks have been developed to test resilience: four credit risk shocks and one liquidity risk shock. These include:
- PRCS-1 & PRCS-2: Based on historical losses from the 2022 and 2025 floods.
- PRCS-3: A hypothetical shock combining vulnerable districts and sectors based on flood hazard rankings.
- PRCS-4: A requirement for banks/DFIs to assess large corporate borrower exposure to flood risks.
- PRLS: A liquidity shock measuring the impact of sudden deposit withdrawals in high flood hazard areas.
5.2 Transition Risk Analysis for Sample D-SIBs
Transition risk analysis involves assessing financial risks resulting from the shift to a low-carbon economy. For sample D-SIBs, the imposition of a carbon tax is a mandatory scenario. Banks are required to adjust the earnings before interest and taxes (EBIT) of corporate borrowers to account for carbon tax expenses, calculate the resulting Interest Coverage Ratio (ICR), and identify exposures where the post-shock ICR falls below 1 as non-performing loans.
Climate Related Data
For an effective stress-testing exercise, the availability of accurate, relevant, reliable and appropriately extensive data in a timely manner is quite crucial. Financial Institutions (FIs) are advised to collect necessary climate-related data that affect their business models. FIs may refer to the National Disaster Management Authority (NDMA), the Pakistan Green Taxonomy, and borrower-specific emission data as required under SECP directives.