FRB Publishes Details of Planned Climate Scenario Analyses at Big Banks
Commentary by Steven Lofchie
The Federal Reserve Board ("FRB") published details on how it plans to conduct its "Pilot Climate Scenario Analysis" exercise and the information it hopes to gather.
As previously covered, the exercise will subject six major U.S. financial institutions to various hypothetical climate scenarios to test each institution's readiness to address such scenarios. The FRB said it plans to publish the findings as guidance for all market participants on mitigating climate-related risk, but would keep the individual details of each organization private.
The FRB said the exercise will feature both physical and transition risks of varying severity so that the banks can estimate the effect of climate-related financial risks on select portfolios. The FRB plans to collect information on (i) governance and risk-management practices, (ii) measurement methodologies, (iii) data challenges and limitations, (iv) estimates of the potential impact on specific portfolios and (v) any information that could potentially inform future climate-related exercises.
The FRB emphasized that the results are not forecasts or policy prescriptions, but rather will be used to help build a better understanding of climate-related financial risks. FRB also stated that it views climate scenario analyses as "distinct and separate from regulatory stress tests," adding that such analyses are "exploratory in nature" and do not have bank capital or supervisory implications.
The FRB stated it plans to publish the findings from the exercise toward the end of 2023.
Commentary
The FRB states in its climate risk exercise, "Challenges [in conducting this analysis] include the forward-looking nature of climate risks and the lack or relevant historical data; complex feedback effects that are difficult to mode; and uncertain links between climate change and economic and financial outcomes." Put differently, a significant challenge to such an analysis is that there is not an established relationship between the input (i.e., climate change) and the output (i.e., bank risk).
Absent a demonstrable connection, the FRB would be hypothesizing that a future negative economic event may occur and that this negative event may be somehow linked to climate change. (Given the season, I would note that various Super Bowl Indicators have a high rate of predictive success as to stock market performance, even though, like the correlation between climate change and bank risk, there is not a demonstrable direct linkage between the two.)
If banking regulators would like financial institutions to take defensive measures with respect to climate change, it is incumbent upon the regulators to demonstrate to financial institutions both (i) the potential for a meaningful amount of climate change within a prescribed period and (ii) that such climate change can be linked with some degree of probability to financial and economic events. If those demonstrations and linkages can be established at some reasonable level of probability, financial institutions and other businesses will respond.
Related Articles
-
The Federal Reserve Board 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 risk.