CSA – The Latest Acronym De-Mystified Implications for Broader Financial Sector

On Jan 17, 2023, The Federal Reserve Board told the six largest US banks – Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley, and Wells Fargo – they have until the end of July to show how their businesses would be impacted by "a range of plausible future outcomes" related to climate change and the transition to a lower-carbon economy. Under this pilot climate scenario analysis (CSA) exercise, the banks are being asked to consider how their real estate portfolios might be affected by extreme weather events caused by climate change (physical climate risk) and how their corporate loans might be affected by the move to reach net zero GHG emissions by 2050 (transition climate risk).

Fed clarified that CSA is being conducted to assess resilience of FIs and is separate and distinct from regulatory stress testing, which is intended to determine whether large banking organizations have sufficient capital to continue lending through an economic recession. So, the CSA should not have regulatory or supervisory consequences or any impact for bank capital as of now. It may be noted that Supervisory Capital Assessment Program in 2009 started with 19 banks and then transformed to encompass a larger gamut of financial institutions. So, it is likely that supervisory expectations for climate scenario analysis will continue to expand.

It may be noted that Climate scenario analysis is now in wide use at the largest financial firms in the US and Europe. Risk identification and assessing the financial impacts of climate change remain the most popular reasons to undertake climate scenario analysis. These firms use the results of scenario analysis to enhance risk management, improve disclosure, and implement revisions in products and services, organizational strategy, and portfolios.

At the beginning of the exercise, the Fed will publish details of the climate, economic, and financial variables that make up the climate scenario narratives.  As part of the climate scenario analysis (CSA), participating organizations will submit data templates, supporting documentation, and responses to qualitative questions to the Federal Reserve by July 31, 2023.

The CSA is intended to help the Federal Reserve gather information about the climate risk management practices of large banking organizations as well as enhance the ability of the organizations to identify, measure, monitor, and manage climate-related financial risks. In some respects, the pilot CSA is similar to a limited information collection exercise that the OCC undertook in 2021 with some of the large financial institutions that it regulates. However, the pilot CSA appears to request significantly more data and analysis from banking organizations than the OCC did in its exercise.

CSA Instructions

The CSA requires participating organizations to analyze the impacts of given climate scenarios as they relate to specific assets in their portfolios. The exercise consists of two modules:

• a physical risk module that represents the harm to people and property that may result from climate-related events such as hurricanes and wildfires. For the physical risk module, the Federal Reserve leveraged the Intergovernmental Panel on Climate Change’s existing work on greenhouse gas emissions concentration trajectories to design its own scenarios. For physical risks, each banking organization must estimate the effect of the scenarios on residential real estate and commercial real estate loan portfolios over a one-year horizon in 2023.
• a transition risk module that represents stresses that may result from the transition to a lower carbon economy. For the transitional risk module, the Federal Reserve used scenarios provided by the Network for Greening the Financial System. For transitional risks, each organization must estimate the effect of the scenarios on corporate loans as well as residential real estate and commercial real estate loan portfolios over a 10-year horizon from 2023 to 2032.

The CSA notes that it will not address any of an organization’s trading book exposures.

The Federal Reserve expects banking organizations to calculate their best estimates of scenario-adjusted Probability of Default and Loss Given Default as of January 1, 2023. Unlike the stress testing conducted through the FR Y-14 information collection process, the Federal Reserve will not require an organization’s chief financial officer to attest to the information submitted for the CSA.

Additionally, the CSA exercise requires participants to submit responses to qualitative questions focused on four primary areas:

• Governance and risk management - The governance and risk management section will discuss the organization’s current practices with respect to managing climate-related financial risks, such as how the organization uses climate scenario analysis to inform its business decisions.
• Measurement methodologies - The measurement methodologies section seeks information about approaches that the organization used in estimating results for each scenario within the two modules.
• Results - The results section requires the participating organization to provide a narrative description of the results under each scenario.
• Lessons learned and future plans - The lessons learned, and future plans section covers issues including how the banking organization expects to use climate scenario analysis to inform its future business decisions and what other approaches or considerations the organization may employ in any future similar exercise.

The Fed will then review firm analysis and engage with those firms to build capacity to manage climate-related financial risks. The Fed anticipates publishing insights gained from the pilot at an aggregate level, reflecting what has been learned about climate risk management practices and how insights from scenario analysis will help identify potential risks and promote risk management practices. No firm-specific information is expected to be released.

Conclusion

Overall-the CSA instructions indicate that the submissions will focus on changes to risk metrics rather than estimates of losses. This limited ambition may reflect the difficulty in quantifying the long-term consequences of climate change over the relatively short horizons used in scenario analysis. Additionally, it may help to head off concerns that regulators are implicitly discouraging banking organizations from making certain loans based on the size of the losses estimated through scenario analysis.

As mentioned earlier and seen in the chart below sourced from GARP’s Fourth Annual Survey of Climate Risk Management, most of the large financial institutions are already using climate scenario analysis for reasons other than regulatory demands.

Irrespective of regulatory requirements, Banks need to manage climate risk as a financial risk and not just reputation risk or regulatory risk. Prudent risk management requires that financial institutions across the size spectrum continue to progress on the path of investigating the impact of climate risk on their profitability and resilience.

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About the Author

Amitabh Bhargava - Senior Managing Director at SRA - is Sustainability & Climate Risk (SCR) Certified Professional by GARP (Global Association of Risk Professional) and leads Credit Portfolio Management and ESG practice at SRA. Amitabh has 25+ years of experience in credit risk management spanning consumer and wholesale lending, including credit risk strategy, risk governance, risk appetite, limit structure, emerging risk assessment, portfolio risk mitigation tools, ESG/sustainability strategy and model calibration process spanning risk rating, pricing and stress testing models. Amitabh is Accredited Credit Risk Certified(RMA-CRC) professional, Financial Risk Manager (GARP), Chartered Financial Analyst (CFA Institute), Sustainability & Climate Risk Certified Professional (GARP), and Board member- RMA Richmond. 

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Sources:

https://www.federalreserve.gov/newsevents/pressreleases/other20230117a.htm

https://www.federalreserve.gov/publications/files/csa-instructions-20230117.pdf

https://www.garp.org/sustainability-climate/fourth-global-climate-risk-survey

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