The Federal Reserve's pilot climate scenario analysis involving six of the largest banks in the country began in earnest on Tuesday.
Formally
Under the scenario, the banks — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo — will have to forecast the impact of a severe hurricane in the Northeast and one additional natural disaster of their choosing elsewhere in the country on their residential and commercial real estate lending portfolios over a one-year timeline.
Also, the banks will have to project the impact of so-called transition risks — which are risks related to commercial, governmental and consumer-level responses to climate change — on their corporate and commercial real estate lending portfolios over a 10-year horizon.
The banks have until July 31 to compile the requested data and submit it to the Fed, though a senior official with the central bank noted that it will take several months to conduct follow-ups with the participating banks and analyze the findings. In total, the official projected the process would take a full calendar year from start to finish.
Unlike the Fed's annual capital stress test, which determines how much of a stress capital buffer the top banks in the country must maintain, the pilot climate stress test is "exploratory in nature," the Fed said in a statement. It will have no capital implications for the banks involved. Also, individual results will not be published. Instead, the Fed will use its findings to determine future courses of action for climate risk supervision.
The senior official declined to comment on whether future iterations of the climate stress test might be used to set capital levels or determine other supervisory standards.
Banks will be evaluated on their ability to handle the physical risks of climate change and the transition risks separately to "better identify critical data, modeling, and risk-management components for each type of risk," according to the instruction booklet published Tuesday.
The physical risk module draws projections from the Intergovernmental Panel on Climate Change, or IPCC, to establish climate conditions in the scenario. These include more frequent and intense heat extremes, marine heatwaves, heavy precipitation, cyclones and drought. For the test, participating banks must apply projected climate conditions in 2050 on their current loan portfolios.
The scenario posits that an extremely large hurricane or series of hurricanes strikes somewhere in the Northeast. It does not specify where, but notes that the Northeast was chosen because all of the banks involved have substantial exposures to residential and commercial real estate in the region. This common scenario was chosen to establish a baseline performance against which all of the banks can be compared.
There are three iterations of the physical loss component of the test: a 100-year return period loss event with insurance coverage, a 200-year return period loss with insurance and a 200-year loss event without insurance.
The second component of the physical test requires banks to come up with their own climate-related risk for a different region of the U.S. — such as an extreme drought in the Southwest or widespread flooding in the Southeast — with two different degrees of severity. These "idiosyncratic" scenarios will face the same iterations as the common one.
Then there is the transition risk portion of the analysis, which includes both policy changes as well and changes in borrower sentiments at the individual, household, corporate and governmental level.
For transition risk, banks will have to account for impacts to their portfolios over a 10-year period based on two transition scenarios. The first establishes a baseline by assuming no new policies, increases in greenhouse gas emissions until 2080 and an increase in global temperatures of 3 degrees Celsius by 2100. The other follows the NetZero 2050 framework established by the Network for Greening the Financial System, or NGFS. These scenarios will also carry multiple iterations.
Banks in the pilot will have to project the annual impacts on their corporate and commercial real estate credit portfolios over a 10-year period. The participants will have to project these policy impacts on probability of default, internal risk rating grades and loss given default projections.
For both the physical and the transition risk modules, the Fed sought to limit the scope to bank activities directly exposed to climate risks, the senior official said, which is why they focus on real estate and corporate risks. Other factors such as trading portfolios, counterparty credit risks and retail credit were not included in either module.
Climate-related analysis has been a controversial topic among bank regulators. Advocates argue it is crucial for banks to monitor the financial stability impacts of global warming while skeptics contend that doing so goes beyond the statutory limitations of agencies such as the Fed.
Since taking office, Barr has emphasized the importance of striking a balance between the two perspectives, by assessing risks without trying to steer market participants toward or away from specific activities.
"The Fed has narrow, but important, responsibilities regarding climate-related financial risks — to ensure that banks understand and manage their material risks, including the financial risks from climate change," Barr said in a written statement released Tuesday afternoon. "The exercise we are launching today will advance the ability of supervisors and banks to analyze and manage emerging climate-related financial risks."
