Federal Reserve Board Building, 1936 (Paul Philippe Cret, architect). The Eccles Building. Credit: Photo by Pedrik, Flickr.
In May 2024, the Federal Reserve Board conducted a pilot Climate Scenario Analysis (CSA) exercise involving six of the largest U.S. bank holding companies—Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo. This exploratory exercise was designed to assess how these major financial institutions manage and understand the potential impacts of climate-related financial risks on their operations.
Objectives of the Pilot CSA Exercise
The primary goal of the pilot CSA was to enhance the ability of both banks and regulatory bodies to identify, estimate, monitor, and manage climate-related financial risks effectively. By simulating both physical and transition risks associated with climate change, the exercise aimed to test the resilience of business models to a range of climate scenarios.
Key Insights from the Exercise
The pilot CSA exercise highlighted varied approaches to climate risk among banks, significant data gaps, and the critical role of insurance in risk mitigation. The unpredictability of climate event timings adds complexity to integrating these risks into existing frameworks.
- Varied Methodological Approaches: The exercise revealed that participating banks utilized diverse approaches to integrate climate risk scenarios into their risk assessments. These varied primarily due to differences in their business models, data accessibility, and previous experiences with similar exercises in other jurisdictions.
- Significant Data and Modeling Challenges: One of the critical challenges highlighted was the lack of comprehensive and consistent data, particularly related to property characteristics and the climate risk management plans of counterparties. Many banks depended on external vendors to supplement these data gaps.
- The Crucial Role of Insurance: The pilot underscored the importance of insurance in mitigating climate risks. The changing landscape of the insurance industry, including fluctuating costs and coverage, was noted as a critical area for ongoing monitoring.
- Concerns Over Indirect and Chronic Risks: Participants acknowledged the need to better understand the broader economic impacts of local disruptions and long-term changes such as sea level rise, which are essential for comprehensive risk management.
- Uncertainty in Risk Measurement: The inherent uncertainties around the timing and severity of climate impacts make it challenging for banks to integrate these risks into their standard risk management frameworks.
Building on these key insights, the exercise delved into specific risk modules to further explore how these challenges manifest in the context of physical and transition risks.
Modules Explored in the Exercise
The Physical Risk Module analyzed the impacts of climate events like hurricanes on real estate portfolios, while the Transition Risk Module evaluated the economic effects of shifting to a lower-carbon economy on asset values and business operations.
- Physical Risk Module: This module focused on the direct impacts of acute climate-related events like hurricanes and floods on banks’ real estate portfolios, examining both immediate property damages and subsequent credit risks.
- Transition Risk Module: It dealt with the financial strains from transitioning towards a lower-carbon economy, capturing risks to asset values and the overall viability of business operations.
The key insights from the pilot CSA exercise, which highlighted varied methodological approaches and significant data challenges, directly informed the focus and findings of the Physical and Transition Risk Modules that assessed the impacts of climate-related events and economic transitions on financial institutions.
Governance and Risk Management Enhancements
The exercise prompted banks to adapt their existing governance frameworks to address the specific challenges posed by climate risks. This adaptation included integrating tailored internal controls and audit processes to ensure compliance and effectiveness in managing these new risk types.
Importance of a Healthy Financial System to Climate Concerns
A healthy financial system is vital for addressing climate concerns as it supports funding for climate initiatives, ensures economic stability, facilitates effective insurance and risk management, allocates resources efficiently, funds innovation and research, and boosts consumer confidence and spending.
Summing Up
The pilot CSA exercise highlighted the complex nature of climate-related financial risks and the critical need for banks to continue enhancing their data handling, modeling techniques, and scenario analysis to capture these risks accurately. As banks work towards these improvements, the insights gained from this exercise will help in shaping better practices and policies to protect the financial system from potential climate disruptions.
Source: Federal Reserve Board. (2024). Pilot Climate Scenario Analysis Exercise Summary: Summary of Participants’ Risk-Management Practices and Estimates. Board of Governors of the Federal Reserve System.