Fed report: Climate change could raise loan defaults for biggest banks

Vapour Rises From A Chimney Stack
The Federal Reserve publicized the results of its climate stress test pilot program Thursday and found that the biggest banks could face higher loan defaults on commercial real estate and residential real estate loans as well as loan defaults related to a decarbonizing economy over the coming decades.
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WASHINGTON — The largest banks could see a potential increase in loan defaults due to climate change and the decarbonization of the economy, according to results of the Federal Reserve's climate scenario analysis issued Thursday. 

Bank of America, Morgan Stanley, Goldman Sachs, Citigroup, JPMorgan Chase and Wells Fargo participated in the exercise, which was announced almost two years ago. The tests required each firm to gather and report data to the Fed which the agency used to draw conclusions. 

The scenario models the impact of a severe hurricane in the Northeastern United States and one additional natural disaster elsewhere in the country — chosen by the bank — on each firm's residential and commercial real estate loan portfolios over the course of a year. The banks used their own models and assumptions to complete the exercise, and the results presented by those models were not independently verified by the Fed.

The scenario is broken into two "modules" of risk associated with climate change. The physical risk module explored the damage inflicted on people and property as a result of shorter term climate events such as wildfires and floods as well as long-term climate change like sea-level rise. The second "transition-risk" module refers to the stresses on various firms, sectors or regions resulting from policy changes, consumer or business sentiments or technologies arising from the ongoing transition to a lower carbon economy. 

As part of the physical risk module, the banks estimated the impact of a hurricane in the Northeast U.S. — a region where all six firms have significant exposure. 

Under the most severe scenario, the Fed measured the impacts of a one-in-two hundred year storm and assumed properties are not insured. The report found that over 1,000 commercial loans and more than 238,000 residential loans in the Northeast would be impacted under such a scenario, representing 20% of commercial real estate loans and 50% of residential real estate loans.

The estimated probability of default for northeast properties spiked by 0.4% and 0.1%, respectively for commercial and residential loans, the study found. This represents about 20 and 50 percent of participants' total northeastern commercial and residential loans, respectively.

A second component of the physical risk scenario asked banks to pick a region relevant to their real estate holdings and perform analysis of the impact of a weather event of their choice. Such "idiosyncratic" shocks had even more pronounced effects of default levels. Probability of default on the uninsured properties increased by 2.6% for commercial and about 1.1% for residential real estate properties.

The Fed had banks assess the impact of transition risk by estimating the difference in the probability of loan defaults under current climate policies with a hypothetical scenario in 2050 where policies achieve net zero carbon dioxide emissions. The average transition risk impact for CRE loans was about 1% across all property types, but the Fed said participants reported significantly varying impacts depending on CRE property types.

The Fed first unveiled its climate scenario analysis test in 2022 to test how six of the largest global systemically important banks respond to various climate-related scenarios. The "exploratory" nature of the tests mean they have no imminent bearing on the banks' capital or regulatory requirements, but rather give regulators a snapshot of large banks' readiness to weather theoretical climate disruptions. 

The tests — implemented by Fed Vice Chair for Supervision Michael Barr — further one of the Biden administration's top goals of addressing climate change. Barr's approach has been to ensure that banks understand climate risks without trying to steer market participants toward or away from specific activities. The Fed, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency adopted final guidance for banks over $100 billion of assets to manage climate risks in 2023.

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