US Federal Reserve Announces Climate Scenario Analysis Program – Financial Services

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On September 29, 2022, the Federal Reserve (“Fed”) Board of Governors announced that six of the largest U.S. banks will participate in a climate scenario analysis program, the first of its kind. The Fed will provide participating banks with “climate scenario stories” including climate, economic, and financial variables that banks will use to analyze the impact of the scenarios on specific portfolios and business strategies (and potentially on their balance sheet and overall health). ). In particular, banks will not be able to choose their own scenarios. The Fed will use bank analytics to encourage them to build capacity to manage climate-related financial risks and will publish aggregate-level information from the program, but not bank-specific information. The Fed will provide additional details on the program in the coming months, but it is expected to launch in early 2023 and wrap up around the end of the year. This pilot program is important because it can be the first step in using stress testing and bank regulatory capital to address climate risks. The Fed and other regulators could start imposing demands on banks in future iterations of climate-related stress tests, rather than just “incentives.”

Following the 2008 financial crisis, stress testing became one of the primary tools used by US banking regulators to ensure the safety and soundness of financial institutions. Annual stress-testing exercises, in which the Fed and other banking regulators specify macroeconomic scenarios of varying degrees of severity, determine regulatory capital levels and shareholder dividends. Banks must demonstrate that they are able to maintain certain minimum capital levels even under externally defined stress scenarios. Failure to do so may force banks to raise capital, withhold dividends, or both. Banks have devoted considerable resources and developed complex frameworks over the past decade to comply with these stress test requirements, including models to predict the performance of business lines and balance sheets in the event of a severe downturn. .

In addition to stress test results, US banking regulators also assess the overall quality of a bank’s stress testing framework and process. Gaps in this framework lead to prudential criticisms, which may be communicated to banks without ever being published or otherwise made public. Banking regulators are also conducting a “horizontal” review of stress-testing frameworks in which banks’ capabilities are compared to each other. These reviews have led to ever-tighter supervisory standards, driving the continual refinement of all banks’ frameworks and stress-testing capabilities toward greater sophistication.

The Fed distinguishes this climate scenario analysis from the stress tests because it says the former will have no capital consequences and because participation in the scenario analysis was not mandatory (at least not formally) . The Fed also says there will be no prudential implications either. That being said, the Fed notes in the same press release that it “will engage with those [participating] companies to strengthen their capacity to manage climate-related financial risks.

Historically, the Fed and US banking regulators have introduced similar prudential expectations to the largest and most sophisticated banks, expanding their scope to include other large banks over time. Similarly, Fed and US banking regulators often announce new legal requirements under the initial guise of pilot programs and guidance that initially do not impose new requirements. Accordingly, banks of all sizes should closely monitor developments around this first climate scenario analysis. Other U.S. banking regulators have signaled plans to provide advice to banks on managing climate risk in the future.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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