On January 17, the Federal Reserve announced that Wall Street’s largest banks in the U.S. would have to undergo a pilot climate scenario analysis (CSA) exercise. The exercise will gauge the resilience of Bank of America, Citi, Goldman Sachs, JP Morgan, Morgan Stanley, and Wells Fargo to both transition and physical risks. 

The exercise is the Fed’s first step to ensuring banks understand and manage the risks of climate change including climate-induced events such as floods, wildfires, hurricanes, heat waves and droughts, and the impacts these have on their loan portfolios and commercial real estate holdings. 

With the CSA, the Fed is using an exploratory approach to understand how banks approach climate risk management and the challenges that they face. The CSA assessment consists of qualitative questions about governance, risk management practices, methodologies, results, and lessons learned, and quantitative analyses on loans using forward-looking scenarios. 

The CSA is using a two-pronged approach for the quantitative analyses, looking at a physical risk perspective – or the harm to people and property from unexpected climate-related events – and transition risks associated with the costs of moving to a zero-emissions economy by 2050. 

The Fed set several forward-looking scenario criteria for both approaches, using IPCC scenarios for physical risk and NGFS scenarios for transition risk. The physical risk module will apply to residential and commercial real estate loans, and investigates the impact of severe weather events on credit risk, with and without insurance to absorb part of the financial impact. 

The severe weather criteria set in the CSA is two-fold:

• The common shock analysis assesses hurricane events impacting the Northeast U.S. in the year 2050 with (1) 100-year return period loss under the SSP2-4.5 pathway with insurance; and (2) 200-year return period loss under the SSP5-8.5 pathway, with and without insurance.
• The idiosyncratic shock analysis follows the same criteria as the common shock analysis using participant-chosen hazard and region.
  

The CSA requires the banks to provide the Fed with credit risk results, such as probability of default (PD) and loss given default for each loan analyzed, and the impact of the events on the banks’ balance sheet.

The CSA should be of interest for all banks in the U.S. since this is the first exercise of its kind required. We should anticipate that this will be the first of more required analysis to come.

Other American banking regulators, the OCC and FDIC, have been researching climate risk activities and both have published climate risk best practice recommendations, but are not yet requiring regulated disclosures. The largest publicly traded banks in the U.S. will likely be subject to the SEC’s final rules on climate risk disclosure, which is targeted for release in April 2023.  

What we won’t see is the final report focusing on aggregate information provided by the banks about how they are incorporating climate risks into their financial plans. There won’t be estimates on total potential losses from the hypothetical events.

To support the exercise's goals of deepening understanding of climate risk management practices and building capacity to identify, measure, monitor, and manage climate-related financial risks, the Board will gather qualitative and quantitative information over the course of the pilot, including details on governance and risk management practices, measurement methodologies, risk metrics, data challenges, and lessons learned.

The pilot exercise includes physical risk scenarios with different levels of severity affecting residential and commercial real estate portfolios in the Northeastern U.S. and directs each bank to consider the impact of additional physical risk shocks for their real estate portfolios in another region of the country. For transition risks, banks will consider the impact on corporate loans and commercial real estate portfolios using a scenario based on current policies and one based on reaching net zero greenhouse gas emissions by 2050. These scenarios are not forecasts or policy prescriptions but can be used to build understanding of climate-related financial risks.

Climate-related financial risks have the potential to affect the safety and soundness of banks through physical and transition risks, which affect various sectors of the economy and may affect access to financial services and fair treatment of customers.

For all banks around the globe, the CSA exercise is a bit of a wakeup call that loan portfolios and real estate holdings are increasingly at risk from the impacts of climate change. 

To learn more about how you can understand and analyze your bank’s risk, request a demo!

‍