Recommendations for the Federal Reserve To Consider for its Climate Scenario Analysis Pilot Program

Federal Reserve

Federal Reserve on Climate Scenario Analysis Pilot Program

A lot of central banks and governmental organizations have already looked into how climate change may affect a financial institution’s assets in their respective nations. The Federal Reserve (Fed) in the United States announced this fall that it would work with six of the biggest U.S. financial institutions — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo — on a pilot project for its own climate scenario analysis the following year.

The Fed’s strategy is an important step in ensuring the stability and safety of the American financial system. The Fed, financial institutions, and the financial system as a whole will probably learn valuable lessons from the pilot scenario analysis exercise that will take place next year.

The specifics of the Fed’s pilot climate scenario research, such as the scenarios and the types of data that will be used, have not yet been made public. We have given the Fed nine recommendations as it begins this significant work:

In the future, add more banks to the trial programme. For instance, all banks in the European Union with assets of at least €30 billion participated in climate stress tests performed by the European Central Bank (ECB). The Fed would cover more than 60 banks if it used the knowledge gained from the ECB analysis and did climate stress tests with banks of the same size in US currency.

Federal Reserve

In the future, the Fed will take the findings of this investigation into account when reviewing each financial institution in more detail. This should take into account capital effects, in line with the ECB’s strategy. Like the ECB’s pilot, it’s feasible that the Fed’s may highlight financial system concerns. If so, it will be crucial for the Fed to address and reduce the risks by taking the proper action. Officials from the Fed have made it clear that this trial programme will not have an influence on how much capital banks need to hold in reserve to cover losses, though.

To more fully account for the climate risk posed to banks, including indirect effects in the study. The systemic dimension of climate risk is emphasised in Ceres’ 2020 report on banks’ transition risk.

As part of the analysis, consider the effects on assets other than a bank’s loans. Our most recent research on derivatives demonstrates how other assets, like derivatives, may increase the impact of shocks inside a financial organisation.

Include firm-level data from client engagements with banks in the analysis.

This is crucial because it would make it possible to replace banks’ assumptions about client risk with more precise client-level data. Many American banks are already talking to their customers about environmental issues. This kind of data has been incorporated by central banks in other countries, such as the Bank of England, Bank of Japan, and Hong Kong Monetary Authority (HKMA), in their individual climate scenario evaluations.

Place a strong emphasis on assessments that examine late and erratic transitions or situations without a transition. Given the delay in the transition thus far, these are scenarios in which the transition to a net zero economy is slower or does not occur. We think the chance of an early and orderly shift to a net zero economy is extremely low because institutions and regulators are still working to integrate climate risk. The NGFS also recognised the increasing likelihood of a disorganized and delayed changeover in September.

Include average loan losses by industry and location in the analysis’s findings, and make those findings public. This will help other financial institutions, especially regional and community banks, evaluate their own risks.