The Federal Reserve’s Climate Principles and Scenario Analysis Pilot Leave Room for Improvement

By Kelsey Condon, Manager, Banking Financial Regulation, and Amy Kvien, Ceres Manager, Financial Institutions, Ceres Accelerator for Sustainable Capital Markets

The Federal Reserve recently took two significant steps to address climate-related financial risks.

Earlier this week, the comment period for the Fed’s request for comment on its draft Principles for Climate-related Financial Risk Management for Large Financial Institutions ended. The Fed also released details last month on how it plans to run its climate scenario analysis pilot for the nation’s six largest banks. Both of these developments are constructive, timely, and well within the agency’s statutory mandate.

The Principles identify practical and familiar steps that financial institutions can take within their current risk management practices. However, the Principles have key shortcomings, which we outlined with detailed recommendations for improvement in comments we submitted to the Fed. In particular, they only target banks with over $100 billion in assets. While we recommend banks with $50 billion or more in assets is a preferable reasonable starting point, all banks face climate-related financial risks, regardless of asset size or business model.

The Principles also fall short in ensuring that banks’ climate risk management strategies do not harm financially vulnerable communities disproportionately by, for instance, making financing more difficult or expensive to obtain.

In contrast, the New York Department of Financial Services’ recently proposed climate risk guidance will apply to all banks regardless of size, and emphasizes the importance of managing these risks while continuing to ensure fair access to capital and credit.

Despite the serious and growing systemic risks climate change poses to our economy, the U.S. financial sector is far more exposed than banks and regulators are accounting for to transition risks posed by changes in regulation, technology, and market preferences as we shift to a net zero economy, and to physical risks from increasing frequency and severity of extreme weather events.

Banks must better understand how these risks fit together and how they can generate indirect effects across the economy, disrupting U.S. financial stability with a disproportionate impact on financially vulnerable communities--which is where climate scenario analysis makes its entrance.

The Fed’s Principles acknowledge these exercises as an important step in measuring and managing climate risk. At least 31 other central banks have already completed or begun these exercises. When the Fed announced last fall that it planned to run a climate scenario analysis pilot with the nation’s six largest banks, Ceres praised this strong step forward in helping protect the resiliency of U.S. financial markets, and provided recommendations for the Fed to consider for this pilot.

However, the details released by the Fed last month on how it plans to run this exercise leave much to be desired. Although we understand the pilot’s purpose is to gain insight into how banks will handle climate-related shocks, we have multiple suggestions to improve future exercises. These recommendations would enable participating banks to more accurately measure the risks their firms face from climate change, and assist smaller banks in building out their own climate risk management frameworks:

1. Include multi-risk scenarios 

In the pilot, physical and transition risk are modeled separately, which may allow for better identification of each risk, but will not capture interactions between risks or compounding effects of multiple concurrent or consecutive events. In future exercises, the Fed should include multi-hazard and multi-risk scenarios to fully understand risks to banks and the banking system.

2. Expand beyond credit risk and incorporate loss calculation 

Similarly, the pilot is limited to credit risk impact. Because pilot results will not analyze impacts on market, operational, and liquidity risk, it will not capture total risk to the banking system from the selected scenarios. Likewise, the pilot lacks an expected loss calculation, which would quantify possible financial losses within a portfolio over the 10-year period of the exercise. This will give an incomplete understanding of the financial impact of the scenarios. It will also not allow participating banks to determine cumulative risks.

3. Broaden physical risk assessment and emphasize current limitations 

We were encouraged to see incorporation of insurance coverage withdrawal in the physical risk assessment. However, the pilot only tests effects on residential real estate and commercial real estate loan portfolios. This limited assessment will not capture the full extent of the risks that banks face or the negative impacts on overlapping bank portfolios. The Fed should explicitly note the limitations of this exercise, and consider adding additional sectors to the next round of scenario analysis, including agricultural, energy, and retail portfolios. It should also include indirect impacts, such as supply chain disruptions and productivity loss.

4. Add a delayed transition scenario 

When it comes to transition risk, the pilot does not include a scenario for analyzing risk posed by a delayed or disorderly transition. A delayed transition carries the highest level of risk, and is the most likely scenario to occur. One of the two scenarios chosen to the pilot, no transition (which means no changes to current policies), also does not address the increased physical risks that would result from taking no action to mitigate climate risks, and is therefore incomplete.

Future iterations of this exercise should include a delayed transition scenario, and should consider the interactions between varying physical and transition scenarios. The Fed should consider providing more structure for how to determine what transition risks banks will face based on bank size or portfolios, to ensure results from different banks are accurate and comparable.

5. Implement a longer time horizon 

The pilot only takes place over a 10-year horizon for transition risk. To fully understand the risks banks face to their safety and soundness, banks need to look at a longer timeframe. While traditional financial risks typically roll out over a few months, the impacts of climate change and its associated risks take place over years and decades. Ceres has produced two reports highlighting the importance of studying longer timeframes, one on the risks to the largest banks from transition to a net zero economy and one analyzing the physical risks of climate change to banks. We recommend future climate scenario analyses use a 20- or 30-year time horizon to better reflect actual risk and provide a more comprehensive analysis for banks and their customers.