FRB Plans to Conduct Pilot Climate Stress Tests with Big Banks
Commentary by Steven Lofchie
The Federal Reserve Board ("FRB") announced the six major U.S. commercial banks that will participate in a pilot climate scenario analysis exercise designed to improve their ability to identify and mitigate climate-related financial risk. The FRB said that the pilot exercise will begin in early 2023 and is expected to run through the year. Participants include Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.
The FRB said that the exercise will subject the financial institutions to various hypothetical climate scenarios to test each bank's readiness to address those scenarios. The FRB stated that it will publish "details of the climate, economic, and financial variables that make up the climate scenario narratives." The FRB pilot program requires the banks to assess the impact of each scenario on its portfolios and business strategies. The FRB stated that it will evaluate each bank's assessment and help to develop a climate-related risk management program. The FRB said that it plans to publish the results of the exercise at an aggregate level as guidance for all market participants on mitigating climate-related risk, but would keep the individual details of each bank private.
The FRB said that this analysis differs from traditional stress testing and there will be no capital or supervisory implications from the pilot program. The FRB said that it will publish additional details on the exercise within the next few months.
Commentary
The results of the stress tests will be determined by the scenarios the FRB creates. The results may be less interesting than the scenarios that the FRB elects to posit. In the current environment, these stress tests may be a variant of the "garbage in, garbage out" adage; there is a risk that the stress tests will be "politics in, politics out."
Some starting questions: Will the scenarios be based on actual changes to climate or potential legal and regulatory events? How far in the future will any material "events" be projected to occur? What individuals or organizations will have had input in the development of the scenarios? How transparent will the FRB be as to the scenarios, the range of scenarios and the basis for their selection?