On September 29, 2022, the Federal Reserve Board (Federal
Reserve) announced in a press release that six of the
largest US banks will participate in a climate scenario analysis
pilot to assess financial risks. The pilot, which will be launched
in early 2023, is designed to enhance the ability of supervisors
and firms to measure and manage climate-related financial risks.
This marks the first time the Federal Reserve has publicly
announced a climate scenario analysis program for supervised
financial institutions, following the precedent set by European
supervisors such as the Bank of England (BoE) and European Central
Bank (ECB), each of whom launched similar programs in 2021 and
2022, respectively.
The announcement comes with little surprise-Federal Reserve Vice
Chair of Supervision Michael Barr previewed the Federal
Reserve’s plans earlier this month, stating it intended to
“launch a pilot micro-prudential scenario analysis exercise to
better assess the long-term, climate-related financial risks facing
the largest institutions.” Moreover, as discussed in a previous advisory, the Federal Reserve has
recently been signaling that it intends to play a major role in
addressing climate-related impacts to the financial system.
Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase,
Morgan Stanley, and Wells Fargo will undergo the climate scenario
analysis exercise, which will assess the resilience of financial
institutions under different hypothetical climate scenarios. The
Federal Reserve said it will release details of the financial,
economic and climate variables comprising the climate scenario
narratives at the pilot launch. During the pilot, the firms will
undertake an analysis of the impact of the scenarios on their
respective business strategies and portfolios. The Federal Reserve
will review the findings and “engage with those firms to build
capacity to manage climate-related financial risks.” The
Federal Reserve did not specify what form that engagement might
take and whether the focus would be on the specific firms, the
overall economy and its financial stability, or both. The Federal
Reserve plans to publish aggregate findings from the pilot, but
will not release firm-specific information.
In its announcement, and as foreshadowed by Federal Reserve
Governor Lael Brainard in February of 2021,1 the Federal
Reserve distinguished climate scenario analysis from its annual
bank stress tests-in which the Federal Reserve tests large
banks’ strength against hypothetical recessions-and the results
of which directly inform how much capital each firm must hold. The
Federal Reserve emphasized that the pilot will be strictly for
information gathering purposes, calling it “exploratory in
nature,” and that it will not have capital consequences.
The pilot is expected to conclude by the end of 2023. The
Federal Reserve has promised to provide additional details on how
the pilot will be conducted, including the scenarios that will be
used, in the coming months.
While the Federal Reserve’s pilot is limited to six banks,
climate scenario analysis is likely to be a reality for other
financial institutions in the near future. The Office of the
Comptroller of the Currency (OCC) and Federal Deposition Insurance
Corporation (FDIC) each have issued proposed principles for how
large financial institutions (over $100 billion in total
consolidated assets) manage climate-related financial risk. Both
the FDIC’s and OCC’s proposed principles include
recommendations that large financial institutions implement climate
scenario analyses to forecast the potential impact on their
institution of changes in the economy or financial systems
resulting from climate-related risk. In a speech to the American Bankers Association
earlier this week, FDIC Acting Chairman Martin Gruenberg reiterated
his agency’s view that large banks should implement climate
scenario analysis. Notably, he stressed that such exercises are
appropriate for “large institutions, particularly for those
that cross multiple communities,” and they are “not
intended for smaller institutions.” He also reiterated that,
as the Federal Reserve has attempted to make clear, climate
scenario analysis “is not a stress testing exercise and will
not have regulatory capital implications.”
Thus, while the industry awaits further word from the Federal
Reserve on how the exercises will be conducted, financial
institutions-particularly those “large banks” in the
intended audience for the FDIC and OCC proposed principles-should
look at the scenarios used in the BoE’s 2021 Climate Biennial
Exploratory Scenario (CBES), as well as the results of that
exercise. Of note, in discussing climate scenario analysis at the
2021 Federal Reserve Stress Testing Research Conference in October
2021, Governor Brainard explicitly stated that the Federal Reserve
is “actively learning” from other financial regulators,
including the BoE, in developing scenario analysis.
The CBES was launched in June 2021 and results were released at
the end of May of 2022. Under the CBES, certain of the UK’s
largest financial institutions conducted an intensive
climate-related stress test, which was aimed at measuring the
financial exposures of participants and the financial system to
climate-related risks, understanding the challenges to
participants’ business models from these risks, and engaging
with participants to assist them in enhancing their management of
climate-related financial risks. Like the Federal Reserve pilot,
the CBES exercise was focused on information-gathering, and is not
intended to be used by the BoE to set capital requirements. While
there are some differences between the CBES and the little we know
about the Federal Reserve’s pilot, such as the participants in
the exercise (the CBES exercise included large UK banking groups
and building societies (i.e., mutual organizations), as well as
large UK life insurers and general insurers), the CBES may provide
somewhat of a crystal ball in how the Federal Reserve will proceed
with its pilot.
The CBES required participants to explore transition risks
(risks that arise as the economy seeks to move from
carbon-intensive to carbon-neutral) and physical risks (risks
associated with higher global temperatures and resulting weather
and climatic events) over three different 30-year scenarios: (1)
Early Action-the transition to a net-zero economy starts in 2021;
(2) Late Action-policy to start the transition to a net-zero
economy is delayed until 2031; and (3) No Additional Action-no new
policies to transition to a net-zero economy. According to the BoE, “the scenarios are
plausible representations of what might happen based on different
future paths of governments’ climate policies (policies aimed
at limiting the rise in global temperature).” For the bank
participants in the CBES, the key consideration was on the credit
risk associated with the banking book under each scenario. A key
metric of that risk to be determined was the cumulative total of
provisions against credit-impaired loans at various points in the
scenarios. Trade book risk was out of scope. This is likely because
of the difficulty-or impossibility-in performing such analyses when
assets in the trading book may be held only for days or less.
Among the key lessons learned from the CBES, the BoE found
that:
- Climate risks captured in the CBES scenarios are likely to
create a persistent and material annual drag on bank and insurer
profits of 10-15% on average; - Projected climate risk impacts were highest for banks’
wholesale and mortgage exposures; - By bank customer sector, the largest proportion of projected
corporate credit losses were mining (including extraction of
petroleum and natural gas), manufacturing, transport, and wholesale
and retail trade; and - Projected bank credit losses were greatest in the Late Action
scenario, with loss rates more than doubling as a result of climate
risks.2
Another key finding from the CBES was the “lack
of data on many key factors that participants need to understand to
manage climate risks.” According to the BoE, this was a
recurrent theme among participants. Moreover, there was a
“range in the quality of different approaches taken across
organisations to the assessment and modelling of these risks.”
Thus, the US regulators are likely to learn from the data quality
issues that hampered the BoE CBES and insist-maybe not in the
Federal Reserve’s inaugural climate scenario analyses, but
eventually-that financial institutions use more relevant and
consistent data and employ enhanced analyses. Ultimately, the BoE
determined that all participating firms have more work to do with
respect to improving their climate risk management capabilities,
and the BoE vowed to engage with firms to help them “target
their efforts, and share good practices identified in this
exercise.”
Conclusion
While much is still unknown about what the future holds for
climate-related regulations and supervisory expectations, the
Federal Reserve’s pilot announcement makes clear that changes
are on the horizon, particularly for larger financial institutions.
Financial institutions of all sizes are encouraged not to delay in
incorporating climate risk into their enterprise-wide risk
assessments and risk mitigation frameworks. If financial
institutions have not done so already, they should promptly begin a
serious consideration of their climate-related risk assessment and
risk management approaches, and consider whether their current
corporate governance framework allows for appropriate monitoring,
reporting and decision-making with respect to climate-related risks
as well as climate-related opportunities.
Footnotes
1 Challenges of Climate Change, delivered at the
“2021 IIF US Climate Finance Summit: Financing a Pro Growth
Pro Markets Transition to a Sustainable, Low-Carbon Economy,”
February 18, 2021 (emphasizing that the Federal Reserve’s use
of climate-related scenario analyses would be distinct from
traditional regulatory stress tests to assess capital adequacy to
sustain market shocks over the short-run. Instead, these
climate-related scenarios would be an “exploratory exercise
that allows banks and supervisors to assess business model
resilience” to range of scenarios over the long-run. Id.
(emphasis added).
id.
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