The Intricacies of Climate-Related Risks on European Banks’ Estimation of Expected Credit Losses: Linking Proper Accounting of Climate Risks to Shareholder Required Returns

Abstract

Global banks face a predicament amidst the dictates of IFRS9 accounting policies. Commencing in 2018, incurred losses plus expected losses are to be reported. Loss allowances on loans and advances should be set aside earlier and should therefore be higher than they would be pursuant to the impairment provisions of IAS39. This paper focused on a sample of the top 40 European banks by assets and assessed the transition from IAS39 to IFRS9 through panel data distinguishing credit risk allowances over distinct IAS39 and IFRS9 periods. Economic climate damage data was obtained from the European environmental agency website, and incurred losses as well as expected credit losses data was fetched from annual financial reports. A null hypothesis indicating that banks had lesser or equal IAS39 incurred losses than IFRS9 expected credit losses was tested and rejected. The relationship between economic damages and estimates of credit losses was investigated using a two-sample t-test and Pearson product-moment correlation. Results revealed that banks have been conservative in estimating credit losses since adopting IFRS9. Consequently, the paper contributes in revealing to banks the need to proactively account for climate damages in the wake of IFRS9. It prompts shareholders to incorporate economic climate-induced damages in risk/return decisions.