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.
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:
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:
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.
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.
Strategic Risk Associates (SRA) provides actionable intelligence, thought leadership and guidance to develop ESG strategy to Financial Institutions of all sizes. Additionally, SRA WatchtowerTM removes the friction, cost and complexity out of risk and performance management, while providing customers with hindsight, insight, and foresight needed to make insightful business decisions. SRA leverages our combined 800 years of experience in banking to help clients aggregate 100’s of manual processes and critical business indicators to create a seamless integrated solution to manage your business.
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.