Recommendations for the Federal Reserve To Consider for Its Climate Scenario Analysis Pilot Program

Dec 19, 2022 3:05 PM ET
Campaign: Climate Change

Original Publication

By Amy Kvien, Kelsey Condon, and Tamar Aharoni

Many central banks and government agencies around the world have already examined the impact of climate change on a financial institution’s assets in their respective countries. In the United States, the Federal Reserve (Fed) announced this fall that it would do its own climate scenario analysis pilot project next year with six of the largest U.S. financial institutions – Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo.  

The Fed’s plan is a significant milestone towards ensuring the safety and soundness of the U.S. financial system. Next year’s pilot scenario analysis exercise will likely be insightful for both financial institutions and the Fed, as well as the financial system as a whole. The Financial Stability Board (FSB) and the Network for Greening the Financial System (NGFS) recently released a report on climate scenario analysis, which outlines findings from these types of exercises by 53 global institutions. The report flags that these exercises may be understating climate exposures and vulnerabilities.  
The Fed has not yet published details on the specifics of its pilot climate scenario analysis, including what the scenarios will be and what kind of data will be used. We have provided nine recommendations to the Fed as it undertakes this important work: 

  • Expand the pilot to more banks in the future. For example, the European Central Bank (ECB) conducted climate stress tests with all banks in the European Union that have assets of at least ​€​30 billion. If the Fed applied the lessons learned from the ECB analysis and conducted climate stress tests with banks of the equivalent size in U.S. dollars, it would cover more than 60 banks. 
  • Include the results of this analysis in the Fed’s broader supervisory review of each financial institution in the future. This should include capital consequences, aligned with the approach that the ECB has taken. It is possible the Fed pilot, like the ECB’s, will unveil risks to the financial system. If so, it will be important for the Fed to take appropriate steps to address and mitigate the risks. However, officials at the Fed have been clear that this pilot program will not impact the amount of financial cushion banks must have on hand to absorb losses.  
  • Include indirect effects in the analysis to capture climate risk posed to banks more comprehensively. Ceres’ 2020 report on banks’ transition risk emphasizes the systemic nature of climate risk, illustrating how banks’ first-round—or direct—losses will be significantly amplified by second-round effects due to the interconnectedness across financial sectors. Incorporating second-round effects could shed light on critical financial stability concerns for these financial institutions and the underlying capital markets.  
  • Assess the impacts to other assets outside of a bank’s loans as part of the analysis. Our recent derivatives report shows that other assets like derivatives could amplify shocks within a financial institution. 
  • Integrate firm-level information from banks’ client engagements in the analysis. This is critical as it would allow incorporation of more accurate client-level data instead of banks’ assumptions of client risk. Many U.S. banks are already engaging their clients on climate issues. Central banks in other jurisdictions including the Bank of EnglandBank of Japan, and the Hong Kong Monetary Authority (HKMA) have included this type of information in their respective climate scenario analyses. 
  • Utilize additional data from other organizations and agencies in their climate analysis. For example, using data on climate risk and disasters from Federal Emergency Management Agency or the Federal Insurance Office could prove insightful, like approaches taken by the Bank of Finland and HKMA
  • Include changes in asset prices and credit ratings as climate physical and transition risk evolve. Climate change will impact asset prices and credit ratings, but there is substantial evidence that the market has not yet priced in climate risk. 
  • Emphasize analyses that focus on late and disorderly transitions or no transition scenarios. These are scenarios in which the move to a net zero economy is slower or does not occur given the delay in the transition thus far. Given that regulators and institutions are still in the early stages of integrating climate risk, we believe there is a very low likelihood of an early and orderly transition to a net zero economy. In September, the NGFS also noted the growing odds of a disorderly and late transition.  
  • Include average losses on loans by sector and geographic region in the results of the analysis and share those publicly. This will aid other financial institutions as they assess their own risks, particularly regional and community banks that have concentrations in certain geographic regions and sectors of the economy. 

We were also pleased to see the Fed release draft Principles for Climate-Related Financial Risk Management for Large Financial Institutions for comment, which align with the draft guidance released by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. These are important steps in addressing climate-related risks to the financial system, and we look forward to learning additional details on the pilot climate scenario analysis in the new year.