On September 29, 2022, the Federal Reserve Board (FRB) announced that six of the largest US banks, which includes Bank of America, Citigroup, Goldman, JPMorgan Chase, Morgan Stanley, and Wells Fargo, will be pioneers to a climate scenario-analysis exercise.
The purpose of the exercise is to improve the financial institutions’ process of measuring and managing climate-related financial risks by determining their resiliency using hypothetical climate scenarios. After the climate scenarios have been executed and analyzed by each bank, the FRB will review and work together with each bank to understand the identified climate-related financial risks and promote better risk management practices. Following the climate scenario analysis, the FRB will release aggregated data on the findings and share how these insights will help identify and guide future climate-related financial risk management practices. The FRB expects to start this pilot program in early 2023, with plans to publish insights on the climate scenario narrative process and its climate, economic, and financial variables by the end of 2023.
When trying to understand the impact of this endeavor, it’s essential to distinguish climate scenario analysis from other bank stress tests. The climate scenario analysis’ purpose is to gain insight into how climate-related financial risks “may manifest and differ from historical experience.”1 Instead of focusing on one specific scenario (i.e., during a recession) and purpose (i.e., large banks to continue lending services to businesses and households) like bank stress tests, climate scenario analysis considers different possibilities of economic and financial situations and climate pathways. The importance of banks thinking outside of the classic bounds of risk management is a message also imparted by the Office of the Comptroller of the Currency (OCC) in a recent interview with their acting Comptroller Michael Hsu. “With climate-related risks,” he said, “I believe we are much more exposed to failures of imagination—not asking enough ‘what if?’ questions.”2 It’s clear regulators want banks to take a new approach to assessing climate-related financial risks, and that they believe classic measures will not be a sufficient means to protecting shareholders, investors, and borrowers.
This pilot could lead to financial institutions being required to conduct climate scenario analysis exercises in the future. Climate-related scenario analysis has already been recommended by the Task Force on Climate-Related Financial Disclosures (TCFD), and the Bank of England conducted a similar exercise in 2021. In publishing their results earlier this year, the Bank of England reinforced the importance of improving climate risk management capabilities through effective scenario analysis in order to support the overall economy’s transition to net-zero. Another interesting takeaway from their exercise was that for many of the participating banks, there was a lack of data, which resulted in a lack of consistency in risk assessment and modeling approaches. To preempt such challenges it will be important that regulatory bodies such as the OCC and the US Securities and Exchange Commission, some of which are working to finalize their climate-related financial risk disclosure proposals, provide guidance on approach and data requirements to ensure consistency.
Overall, the results of this exercise will allow the FRB and banks to gain insight on how to prepare for, understand, and in turn, better manage climate-related financial risks.
Given today’s environment, we recommend financial institutions begin preparing for climate scenario analysis now:
Special thanks to Ashley Choi, Maggie Purcell, and Eleanor Gass for contributing to this article.