The Fed’s climate-related risk pilot comes with a long to-do list for banks

The news: The six major US banks that agreed to conduct climate-related scenario analysis with the Fed are kicking off their journey with a long to-do list, per American Banker.

The specifics: In October 2022, the Fed announced a pilot stress test exercise in partnership with Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley, and Wells Fargo that would begin in early 2023. With the new year, the pilot is kicking off with an extensive list of scenarios that each bank is expected to examine.

Physical risks: All banks must project the impact of a severe hurricane hitting the Northeastern US, and each bank also must model a second natural disaster of its choosing. The analysis will cover a one-year period.

  • The banks will assess the impact of the natural disasters on their commercial and real estate lending portfolios.
  • The three projections for each natural disaster include: a 100-year return period loss event with insurance coverage; a 200-year return period loss with insurance; and a 200-year loss event without insurance.
  • The analysis will also project climate changes out to the year 2050, including heat extremes, marine heatwaves, heavy precipitation, cyclones, and droughts.

Transition risks: All participant banks must also assess risks associated with commercial, government, and consumer responses to climate change within their commercial and real estate portfolios over a 10-year period.

  • Two scenarios will measure the impact of policy changes as well as sentiment changes at the individual, household, corporate, and government level: a baseline scenario of no new policy changes, a global increase in temperature of 3 degrees Celsius by 2100, and increases in greenhouse gas emissions until 2080; as well as a second scenario developed by the Network for Greening the Financial System.
  • Each of these scenarios will have multiple iterations.

The results: The banks are required to complete the analysis and turn over results to the Fed by July 31. The Fed will use the rest of the year to review the analysis and follow up with participants.

  • The Fed calls the testing “exploratory” and said the results won’t influence capital reserve requirements at the participating banks. But that doesn’t mean similar tests in the future won’t influence these requirements.
  • The Fed will publish the results in aggregate and will only consider the banks’ lending portfolios. Other business areas, like trading portfolios and retail credit, won’t be included in this round of testing.

Our take: These detailed plans raise questions about the pilot and how banks will respond to a request for such complex analysis that will only be used for informational purposes.

  • Tight deadlines: The July 31 deadline doesn’t leave very much time for the participant banks to conduct their analysis. Big initiatives often take weeks to months of planning, and even during the execution phase, banks must plan for unexpected hurdles and other delays. Since participants have known about the pilot since October, it's likely they’ve done some preparation—but it’s not clear if they knew the extent of the requirements.
  • Shrinking capacity: Such robust analysis will also require significant manpower. The degree of testing needed isn’t something that employees will be able to take on in addition to their daily roles, so banks will likely need to create dedicated teams for testing. But many banks are cutting costs for 2023 and shrinking their workforces.
  • Unclear authority: Some bank regulators are divided on which agencies have authority to evaluate climate-related risks in the sector. Agencies like the Fed and the Office of the Comptroller of the Currency (OCC) believe it’s their duty to ensure the safety and soundness of the US banking system, including monitoring climate risks. Other agencies, like the Federal Deposit Insurance Corporation (FDIC), warn that too many climate-related rules and regulations could put undue burden on some banks, especially smaller community banks that would struggle to cover new expenses and additional work.

This article originally appeared in Insider Intelligence’s Banking Innovation Briefing—a daily recap of top stories reshaping the banking industry. Subscribe to have more hard-hitting takeaways delivered to your inbox daily.