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 project to assess financial risks. The pilot project, which will launch in early 2023, is designed to build the capacity of supervisors and companies to measure and manage climate-related financial risks. This is 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 the European Central Bank ( BCE), each of which has launched similar programs. programs in 2021 and 2022, respectively.

The announcement comes with a small surprise – Federal Reserve Vice Chairman of Oversight Michael Barr outlined the Federal Reserve’s plans earlier this month, saying it intended to “launch a pilot microprudential scenario analysis exercise to better assess the long-term climate-related financial effects”. risks faced by the largest institutions. Additionally, as noted in a previous advisory, the Federal Reserve recently signaled that it intends to play a major role in addressing climate-related impacts on the financial system.

Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo will be the subject of a climate scenario analysis exercise, which will assess the resilience of financial institutions under different hypothetical climate scenarios. The Federal Reserve said it would release details of financial, economic and climate variables including climate scenario narratives when the pilot is launched. During the pilot, the companies 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 these companies to build their 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 specific companies, the overall economy and its financial stability, or both. The Federal Reserve plans to release aggregate results from the pilot, but will not release company-specific information.

In his announcement, and as announced by Federal Reserve Governor Lael Brainard in February 2021,1 the Federal Reserve has distinguished climate-scenario analysis from its annual banking stress tests – in which the Federal Reserve tests the strength of large banks against hypothetical recessions – and the results of which directly inform the amount of capital that each company must hold. The Federal Reserve stressed that the pilot will be strictly for information-gathering purposes, calling it “exploratory in nature,” and that it will have no capital consequences.

The pilot is expected to be completed 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 project is limited to six banks, climate scenario analysis is expected to become a reality for other financial institutions in the near future. The Office of the Comptroller of the Currency (OCC) and the Federal Deposition Insurance Corporation (FDIC) have each proposed principles for how large financial institutions (over $100 billion in total consolidated assets) manage risk climate finance. The principles proposed by the FDIC and the OCC include recommendations that large financial institutions should implement climate scenario analyzes to predict the potential impact on their institution of changes in the economy or financial systems resulting from risks. related to climate. In a speech to the American Bankers Association earlier this week, Acting FDIC Chairman Martin Gruenberg reiterated his agency’s view that major banks should implement climate scenario analysis. Notably, he stressed that such exercises are appropriate for “large institutions, especially those that cross multiple communities,” and are “not intended for smaller institutions.” He also reiterated that, as the Federal Reserve tried to make clear, the climate scenario analysis “is not a stress-testing exercise and will not have regulatory capital implications.”

So, while the industry awaits further information from the Federal Reserve on how the exercises will be conducted, financial institutions – particularly “big banks” in the intended audience of the FDIC’s proposed principles and the OCC – should review the scenarios used in the BoE report. Exploratory Scenario of the 2021 Climate Biennale (CBES), as well as the results of this exercise. It should be noted that 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 was “actively learning” other financial regulators, including the BoE, in developing scenario analysis.

The CBES was launched in June 2021 and the results were published at the end of May 2022. Under the CBES, some of the largest financial institutions in the UK conducted an intensive climate-related stress test, which aimed to measure the participants’ financial exposures and the financial system to climate-related risks, understand the challenges posed to participants’ business models by these risks, and engage with participants to help them improve their management of climate-related financial risks. Like the Federal Reserve’s pilot project, the CBES exercise was focused on gathering information and is not intended to be used by the BoE to set capital requirements. Although there are some differences between the CBES and what little we know about the Federal Reserve pilot, such as the participants in the exercise (the CBES exercise included major UK banking groups and building societies (c ie mutual organizations), as well as large life insurers and general insurers), the CBES can provide a kind of crystal ball on how the Federal Reserve will proceed with its pilot project.

CBES asked participants to explore transition risks (risks that arise when the economy seeks to move from a carbon-intensive to a carbon-neutral economy) and physical risks (risks associated with higher global temperatures and resulting weather and climate events) over three different 30-year periods. scenarios: (1) Early Action – the transition to a net zero economy begins in 2021; (2) The late action policy to initiate the transition to a net zero economy is postponed to 2031; and (3) No further action – no new policies to move to a net zero economy. According to the BoE, “scenarios are plausible representations of what could happen given different future trajectories of governments’ climate policies (policies aimed at limiting global temperature rise).” For banks participating in CBES, the main consideration was the credit risk associated with the banking book in each scenario. A key measure of this risk to be determined was the cumulative total of credit-impaired provisions at various points in the scenarios. Commercial portfolio risk was out of reach. This is likely due to the difficulty or impossibility of performing such analyzes when assets in the trading book can only be held for days or less.

Among the main lessons learned from the CBES, the BoE found that:

  • The climate risks taken into account in the CBES scenarios are likely to create persistent and significant annual pressure on the profits of banks and insurers of 10 to 15% on average;

  • The projected impacts of climate risk were highest for banks’ wholesale and mortgage exposures;

  • By banking customer sector, the largest proportion of companies’ projected credit losses were mining (including oil and natural gas extraction), manufacturing, transportation, and wholesale and retail trade; and

  • Projected bank credit losses were highest in the late action scenario, with loss rates more than doubling due to weather risks.2

Another key finding from 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 recurring theme among participants. Additionally, there was a “range in the quality of the different approaches taken by organizations to assessing and modeling these risks”. Thus, U.S. regulators are likely to learn from the data quality issues that have plagued the BoE’s CBES and push — perhaps not in the Federal Reserve’s inaugural climate scenario analyses, but eventually — to that financial institutions use more relevant and consistent data and employ improved analytics. Ultimately, the BoE determined that all participating companies still had work to do to improve their climate risk management capabilities, and the BoE pledged to engage with companies to help them “target their efforts and share the good practices identified in this exercise”.

Conclusion

While it is still unclear what the future holds for climate-related regulations and oversight expectations, the Federal Reserve’s pilot announcement makes it clear that changes are on the horizon, especially for large financial institutions. Financial institutions of all sizes are encouraged to start integrating climate risk into their enterprise-wide risk assessments and risk mitigation frameworks early. If financial institutions have not already done so, they should quickly begin to seriously examine their approaches to assessing and managing climate-related risks, and determine whether their current corporate governance framework allows for monitoring, reporting and appropriate climate decision-making. – related risks as well as climate-related opportunities.

Footnotes

1 Challenges of Climate Change, presented at the “2021 IIF US Climate Finance Summit: Financing a Pro Growth Pro Markets Transition to a Sustainable, Low-Carbon Economy”, February 18, 2021 (noting that the Federal Reserve’s use of the scenario linked These analyzes would be distinct from traditional regulatory stress tests aimed at assessing the adequacy of capital to withstand short-term market shocks. Instead, these climate-related scenarios would be an “exploratory exercise that allows banks and supervisors to assess the resilience of the business model” to a range of long-term scenarios. Id. (emphasis added).

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