Fed's Brainard backs stress test-like exercise to address climate risks

WASHINGTON — Federal Reserve Board Gov. Lael Brainard sounded support for measuring the impact of climate change on financial institutions.

Subjecting lenders to a "scenario analysis" could help identify the risks they face from both extreme weather events and the transition to a greener economy, Brainard said, as well as project the potential financial effects.

“In light of the high uncertainty inherent in estimating climate risks, scenario analysis may be a helpful tool to assess the microprudential and macroprudential implications of climate-related risks under a wide range of assumptions,” Brainard said in a speech Thursday for an event hosted by the Institute of International Finance.

With some in the industry worried that the Fed is considering expanding its stress test regime to account for climate change risks, Brainard stressed that “scenario analysis is distinct from our traditional regulatory stress tests at banks.”

Bloomberg News

“Scenario analysis is an exploratory exercise that allows banks and supervisors to assess business model resilience to a range of long-run scenarios,” she said. “It seeks to understand the effects of climate-related risks on a range of financial markets and institutions, as well as the potentially complex dynamics among them."

“By contrast," she continued, "traditional stress tests are a regulatory exercise to assess the capital adequacy of banks to specific macroeconomic scenarios and financial market shocks over the short run.”

The Fed recently joined the Network for Greening the Financial System, made up of more than 80 central banks and regulators that conduct information sharing on best practices to protect the financial system from climate change. The network released a technical document in June for regulatory authorities considering climate scenario analysis.

“The forward-looking nature of climate risks and the inherent uncertainty about future events make it difficult to assess them using standard risk modelling methodologies,” the paper said. “Scenario analysis offers a flexible ‘what-if’ methodological framework that is better suited to exploring the risks that could crystallise in different possible futures.”

Brainard said in her speech that the Fed is monitoring climate scenarios being developed by other countries “so we can learn from their experiences.”

“It will be important to think carefully about the potential for scenario analysis to support microprudential and macroprudential objectives and to consider how stress testing and scenario analysis may complement one another,” she said.