Climate Risk Gets Personal for Japan’s Biggest Banks

Key Takeaways

• Focus on Transition Risk: Japan’s FSA and BOJ worked with three major banks to assess short-term (7-year) climate-related credit risks, focusing on how policy shifts could affect loan portfolios.
• Custom Stress Scenario Introduced: A tailored scenario was added to test the impact of delayed adaptation and weak carbon price pass-through, especially in high-emissions sectors.
• Banks Show Progress, But Gaps Remain: While modelling capabilities improved, challenges persist around data quality, scenario assumptions, and integration with existing risk frameworks.
• Exercise Aimed at Learning, Not Forecasting: The analysis wasn’t about predicting losses, but about identifying blind spots and strengthening financial resilience in the face of climate uncertainty.

Deep Dive

What happens to a bank’s balance sheet when climate policy tightens and the real economy isn’t quite ready for it? That’s the kind of question Japan’s financial authorities are starting to ask more seriously, and they’ve just completed their second round of climate stress testing to try to get a clearer picture.

The Financial Services Agency (FSA) and the Bank of Japan (BOJ), working closely with three of Japan’s biggest banks, released their latest joint report on climate-related risk scenario analysis, offering a rare look into how the country’s financial sector is gearing up for a carbon-constrained future.

This wasn’t about predicting precise losses or handing out grades. Instead, the exercise (like the first one before it) was designed to stress the system’s thinking and uncover blind spots in how banks identify and respond to climate-related risks. At the center of the exercise: credit risk. Because in banking, loans are where the rubber meets the road, and climate change could very well burn that rubber.

Same Question, Sharper Lens

Compared to the earlier pilot, this second analysis took a more focused, short-term approach, zooming in on the next seven years (FY2024–FY2030) instead of stretching all the way to 2050. It also introduced a more refined, bottom-up methodology, allowing each bank to use its own sector-specific models while keeping assumptions aligned.

Three scenarios were on the table:

1. Current Policies: A business-as-usual path with no extra decarbonization push.
2. Net Zero 2050: A well-managed green transition hitting the 1.5°C target.
3. Net Zero 2050—Adjusted: The wildcard scenario, where companies and households drag their feet on adaptation, and businesses can’t pass carbon costs onto customers. It’s this last one that really tested the banks.

Under that adjusted scenario, GDP growth slows, emissions costs bite harder, and profitability nosedives—particularly in carbon-heavy sectors. For banks, that spells credit risk. Still, the regulators were careful to note: the losses estimated through FY2030 would remain well below the average annual net income of the participating banks. No meltdown in sight—yet.

Progress, But Still Plenty of Work Ahead

Encouragingly, the FSA and BOJ found that banks had stepped up their game since the first go-around. Their models were broader, more detailed, and better documented. There was also more clarity in how they ran their assumptions and ran sensitivity checks.

But this is climate risk, not a problem you solve with a better spreadsheet. The analysis exposed several ongoing challenges:

• Mismatch Between Models and Reality: Many borrower-level transition strategies don’t neatly align with the big-picture scenarios banks are using. That’s a data and design problem.
• Uncertainty Still Reigns: The results were highly sensitive to small tweaks, like how much companies could pass on carbon prices. That’s a warning signal for how assumptions shape outcomes.
• Hard to Plug Into Daily Risk Management: Climate scenario analysis still floats in a silo. Bridging it with day-to-day credit risk frameworks remains a tall order.
• Data Quality Isn’t There Yet: Reliable, granular disclosure from borrowers, especially on emissions and transition plans—is still spotty at best.

Still, the point of this exercise wasn’t to come out with all the answers. It was to move the needle. And by that measure, Japan’s regulators seem satisfied.

A Long Game in a Warming World

The BOJ and FSA made clear they’re not stopping here. They’ll continue working with financial institutions to fine-tune climate risk tools, improve data flows, and make sure climate scenario analysis doesn’t live on the sidelines but gets embedded into real-world banking decisions.

For now, this latest exercise shows that Japan’s financial system is not just waking up to climate risk, it’s starting to ask smarter questions, test harder cases, and treat uncertainty not as an excuse for inaction, but as a reason to get better at imagining what’s coming next.

As climate pressures grow, and policy turns up the heat, scenario analysis won’t predict the future. But it might just help the system avoid being blindsided by it.

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