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Oil price drop a 'real, live' climate stress test for banks

The oil price crash coupled with the economic impact of the new coronavirus might be the tipping point for European banks in accelerating their fossil fuel divestment, as it puts the sector through conditions that almost mirror a climate stress test, according to experts.

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Oil prices plunged more than 30% on March 9 to their lowest levels since the beginning of 2016 amid a price war between Saudi Arabia and Russia. Along with falling demand, this pushed Brent crude from $65.92/barrel on Jan. 1 to a closing low of $24.88 per barrel March 18, its lowest since September 2003. NYMEX WTI light sweet crude futures, a highly liquid benchmark of oil pricing, were edging toward $20 a barrel March 29.

"What we are seeing right now is almost a stress scenario of a sudden transition," said Nina Seega, research director for sustainable finance at the University of Cambridge's Institute for Sustainability Leadership. "We are seeing a dip in the number of people flying, we are seeing a dip in the travel numbers, we are seeing a reduction in production."

"This is as close to a very real, live stress test as we are going to have."

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European banks have come under increasing pressure from supervisors and shareholders who are concerned that banks are financing industries that might become obsolete.

Many banks acknowledge the stranded asset risk and are withdrawing gradually from fossil fuels. French bank BNP Paribas SA has stopped financing shale and oil sands projects. Crédit Agricole SA announced in 2019 that it will exit all thermal coal funding in EU and Organization for Economic Cooperation and Development countries by 2030 but BankTrack, a civil society group that monitors lenders' fossil fuel exposures, called on Crédit Agricole to also speed up efforts to cut oil and gas financing.

Current events should push banks "to prepare for a similar shock because of climate change," said Zacharias Sautner, professor of finance at the Frankfurt School of Finance and Management. "It will accelerate the whole process, the divestment process, the engagement process"

Some U.S. banks with significant oil exposure have already seen credit quality issues, leading to concerns of increased defaults.

"If you have borrowers that have already suffered difficult economic situations, these types of additional impacts can push them over the edge," said Ilya Khaykin, a partner in Oliver Wyman's New York-based Financial Services practice.

Potential capital impact

Analysts' calculations of individual European lenders' gas and oil exposures vary widely, largely because banks do not disclose their activities in the same way.

JPMorgan analysts, however, concluded in a report that in a "severe stress outcome," European banks would suffer a 260-basis-point decline in their common equity Tier 1 ratio — a key measure of financial strength — but capital would remain above requirements, with most banks able to pay dividends with an average yield of around 4% and a 10% to 15% downside risk to share prices.

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They highlighted French investment bank Natixis as one of the most exposed, with oil and gas financing accounting for 6.4% of its exposures at default — a bank's total exposure when a borrower defaults. Crédit Agricole came next with an exposure at default of 5% and then DNB ASA at 4.9%, while at Commerzbank AG, ING Groep NV, Skandinaviska Enskilda Banken AB, Barclays PLC, Société Générale SA and BNP Paribas, the exposures at default ranged from 3.3% to 1.8%.

Analysts at Jefferies estimated a 3% loss on oil and gas loans would shave an average of 28 basis points off European lenders' CET1 ratios, with ABN Amro Bank NV the worst affected, followed by Natixis and Crédit Agricole, but said oil and gas exposure does not yet present a "material risk" to capital and earnings.

READ: How an oil price collapse could impact earnings at Norway's DNB

Jefferies analysts said they measured "risky exposures" relative to each bank's equity base. "Typically we would be concerned when risky exposures near 100% of equity. On this front, only Credit Agricole has oil and gas exposures [at more than] 100% of common equity; ING is also high at 82%."

UBS analysts said the oil price fall "reinforces the urgency" for banks to reduce their fossil fuel exposure. "We believe it won't be long before broader climate change risks are priced," they said in a report. "To influence the evolution of their cost of capital, banks [probably] have to derisk and provide more detailed and comparable disclosure."

Shareholder pressure

The falls in oil majors' share prices might also increase shareholder pressure on banks, Sautner said. Total SA's shares have fallen 46.39% over the past year, while Royal Dutch Shell PLC's are down 56.23%. Banking shares across the board have also been hit, with the STOXX Europe 600 Bank index down 40.39% over the same period.

"If there is any bank that is not fully aware of the consequences of climate change given what happened [in mid-March], it would violate its duties toward shareholders," Sautner said.

The vulnerability of banks that has been exposed in recent weeks is "a telling preview of what lies in store over the next 10 to 15 years," said Greig Aitken, finance researcher at Global Energy Monitor. "If banks don't take policy measures to restrict their exposure to oil and gas, then they will continue to store up risks, and increasing shareholder revolts can be expected."