Climate Scenario Analysis for Fun and Profit
For those who think the Federal Reserve Board only cares about interest rates, the central bank is also concerned about climate change. At least concerned enough to look at whether there could be risks to the banking system from the weather.
The agency announced earlier this month a Pilot Climate Scenario Analysis Exercise, which is government-speak for a climate stress test. However, the Fed was quick to point out the climate scenario analysis is not related to, or a part of, other “stress tests” administered by the central bank.
“This board views climate risk scenario analysis as distinct and different from regulatory stress tests,” the Fed wrote in the participant instructions for the exercise.
The Fed added the exercise is not intended to produce forecasts of policy plans and will not represent the most likely outcomes or even a comprehensive list of possible outcomes.
To ensure any and all observers that this is an exercise, only an exercise, the Fed document emphasized the program “is exploratory in nature and does not have consequences for bank capital or supervisory implications.”
Still, the agency also acknowledged climate change could present physical and transitional risks to banks and “both can manifest as traditional prudential risks for large banking organizations.”
While banks are not required to be part of the exercise, a “prudential risk” is something they have to take seriously. Prudential risk regulations are designed to protect the stability of the banking system and protect deposits by limiting the types of risks banks can undertake.
That’s probably why the issue is important enough for six major bank holding companies – Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo – to agree to participate.
This is not a case of industry leaders working with federal regulators to write their own oversight rules, but an acknowledgment that climate change could affect the stability of the banking system. After the sub-prime mortgage meltdown and Great Recession of the aughts, regulators have taken a fresh look at how the oversight system worked, and more importantly, how it failed.
The regulatory stress tests the Fed explicitly mentions in the participant instructions are a standard feature of banking regulation, and while they are separate and distinct from the climate scenario exercise, they are likely to serve as a model if similar requirements are placed on banks as additional risk management.
Even though the exercise is not intended to produce new policies or regulations, it is an important step in acknowledging that the landscape of risk management is changing, and there are likely even more challenges on the horizon as society evolves and the global economy matures.
Or to put it another way, it’s the regulatory equivalent of saving for a really rainy day.