Federal regulators are warming to scenario analysis as an emerging tool to evaluate financial institutions’ vulnerability to climate risk, drawing criticism from at least one Senate Republican.
The Federal Deposit Insurance Corporation and the Federal Reserve are rallying behind scenario analysis, which involves examining the economic ramifications of hypothetical situations on companies and the market at large.
Martin J. Gruenberg, acting chairman of the FDIC, this week emphasized the agency’s support for the process in a speech on climate risk. Gruenberg said the FDIC’s mission to maintain stability and public confidence in the U.S. financial system includes considering climate change’s adverse impacts on the financial system.
“Climate-related scenario analyses should be designed and used by institutions for building knowledge and capabilities associated with climate-related financial risk management, as well as for better understanding gaps in methodologies and data,” he said in a speech at the the American Bankers Association’s annual convention.
The FDIC is finalizing a framework to manage exposure to climate-related financial risks that would support banks’ use of scenario analysis.
Meanwhile, the Fed announced that six of the nation’s largest banks will participate in a climate analysis exercise next year, marking a potentially monumental move for U.S. financial institutions on addressing climate risk.
Bank of America Corp., Citigroup Inc., Goldman Sachs Inc., JPMorgan Chase & Co., Morgan Stanley and Wells Fargo & Co. will participate in the pilot, the Fed said last week. Through the trial, the central bank will assess the resilience of the financial institutions under different hypothetical climate scenarios.
These moves are already drawing criticism from Republicans.
Senate Banking ranking member Patrick J. Toomey, R-Pa., slammed the central bank’s pilot as an initial move to discourage banks from investing in energy companies and other firms in carbon-intensive industries.
“The real purpose of this program is to ultimately produce new regulatory requirements,” Toomey said in a statement. “While the Fed can call this pilot program by whatever name it may prefer, it sounds exactly like a stress test to me.”
The adoption of scenario analysis was one of the top recommendations from the Financial Stability Oversight Council’s report last year on climate risk in the financial system. FSOC, which is made up of leaders of the top banking and financial regulators, including the FDIC and the Fed, identified climate risk as an “emerging threat to the financial stability of the United States” and encouraged council members to use the recommendations as appropriate in their agencies.
Democrats such as Sens. Elizabeth Warren of Massachusetts and Brian Schatz of Hawaii; left-leaning advocacy groups; and investors concerned with environmental, social and governance issues have ratcheted up pressure on banks to do more to factor climate risk into their business strategies.
The six banks participating in the Fed’s pilot all faced shareholder proposals this proxy season asking the companies to stop financing new fossil fuel development. All those proposals failed to garner majority votes at the companies’ annual meetings.
“The exercise could benefit bank credit profiles over time to the extent it identifies gaps in banks’ data collection and risk governance and builds U.S. regulatory competence around systemic climate risks, which has lagged other developed markets,” Fitch Ratings said in a note this week on the Fed’s announcement.
While the timing for incorporating scenario analysis into financial regulations and the potential ramifications remains uncertain, there will likely be more action in the coming months, Fitch said.
Fed Vice Chair for Supervision Michael Barr last month indicated the central bank, the FDIC and the Office of the Comptroller of the Currency would work together to create guidelines for large banks on managing climate risks to help reduce banks’ vulnerability to long-term climate shocks.
Contradicting Toomey’s statements, the FDIC’s Gruenberg and the Fed emphasized that climate scenario analysis is separate from bank stress tests, which determine whether banks have enough capital to continue lending to households and businesses during a severe recession.
“To be clear, I view scenario analysis as an exploratory risk management tool designed to better understand the range of climate-related financial risks that may impact a large, individual institution and the financial system as a whole,” Gruenberg said. “Scenario analysis is not a stress testing exercise and will not have regulatory capital implications.”
The Fed said its climate scenario analysis exercise “is exploratory in nature” and none of the banks would face capital or supervisory implications because of participating in the pilot.
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