Earlier this month, the Federal Reserve Board provided details on how it will conduct its pilot climate scenario analysis focused on the six largest US banks. These tests will focus on both the physical risks of climate change and on the transition risks that banks are exposed to as the world moves away from fossil fuels. The six banks that will “take” the tests are JPMorgan Chase, Citigroup, Goldman Sachs, Bank of America, Morgan Stanley and Wells Fargo.
The first part of the test will focus on the risks of a hypothetical hurricane in the Northeast, as all banks have a large real estate loan exposure in this region. The second part of the test will assess the risk of bank portfolios if the United States is on track to reach net-zero targets by 2050. Such a scenario could negatively affect these banks, as they are currently large financiers of fossil fuel interests.
Participating banks have until July to complete their assessments, with the Fed publishing the results later in the year.
While this exercise will provide investors with some useful data, critics argue that stress tests don’t go far enough. They have a point.
As currently structured, the US stress tests focus primarily on the impact of real estate and corporate lending. They do not take into account increased risk at the systemic level, especially in a net zero scenario by 2050 that will affect all sectors of the economy. The Fed’s assumptions are also largely based on the use of carbon credits. This faith in carbon credits may be unfounded, as The Guardian’s latest exposure is just the latest in the not-so-useful carbon offsets. The carbon offsets that are chosen are often the cheapest, which often means the offsets with the least auditing and oversight.
The test results will not affect the capital requirements of US banks, but the low test scores could prompt calls for more oversight from the Federal Reserve on weather.
The Bank of England was first
The Bank of England was the first to publish the results of climate stress tests for banks in May. Some of the findings include:
- The weather risks captured in the Biennial Climate Exploratory Scenario (CBES) scenarios are likely to create a drag on UK bank and insurer profitability.
- Costs for banks and insurers will be lower with well-managed early action to reduce greenhouse gas emissions.
- Government policy will be key in determining the speed and shape of a transition.
- The scenario projections are uncertain, as climate scenario analysis is still in its infancy.
- There may be a reduction in insurance lending to sectors that are more exposed to physical risks.
Grades are not very good in Europe
The latest stress tests conducted by the European Central Bank (ECB) in 2022 found that most banks do not include climate risk in their credit models. A total of 104 banks participated in these stress tests, with 41 banks undertaking a more rigorous examination of climate scenario analysis.
The results revealed that around 60 percent of European banks still do not have a climate risk stress testing framework in place. The study found that only 20 percent of banks consider climate risk as a variable when making loans, and about two-thirds of banks’ revenue from non-financial corporate clients comes from greenhouse gas-intensive industries.
The stress tests showed that credit and market losses from a hypothetical near-term disorderly transition and two physical risk scenarios amounted to about $76 billion in total for the 41 banks subjected to the most rigorous test. However, the ECB noted that this result likely underestimates the actual weather-related risk, as it reflects only a fraction of the actual hazard, due to: the paucity of data available at this early stage, the model underlying the projections of the banks that only captures weather factors in a rudimentary way, excluding economic downturns and spillovers from the scenarios, and exposures within the scope of this exercise only account for about a third of the total exposures of the 41 banks that formed part of the most rigorous test. Clearly, in the future, the scope of these tests must be extended so that the total climate exposure of all European banks can be assessed.
We’re not talking about apples to apples here.
One challenge with these different stress testing systems is that they are not always comparable. What the Fed will do in the US is different from the Bank of England, which is still different from the ECB. In fact, other jurisdictions will have different stress tests as more market regulators and financial authorities adopt climate stress tests.
The Network for the Greening of the Financial System (NGFS) addressed this issue in a recent paper, reviewing efforts so far (through the end of 2022) and taking a critical look at the testing processes. stress. The NGFS notes that these stress tests are primarily an awareness raising exercise at this point, and that these stress tests will need to improve and become more comparable to be useful.
The NGFS notes that many of these climate scenario exercises do not find severe impacts under an orderly scenario, but report more significant GDP and financial losses for disorderly transition scenarios. They also acknowledge that these exercises are largely exploratory in nature, as each central bank is just beginning this process. Therefore, stress tests are not designed to be comparable to traditional stress tests or to assess resistance to tail risks. The NGFS agrees with critics of these tests in noting that exposure and climate vulnerability are likely underestimated in the stress tests and that the tests do not capture secondary impacts. Many exercises also failed to consider other potentially important sources of risk, such as those arising from an abrupt correction in asset prices when transition shocks result in forced sales of assets in exposed sectors.
Finally, the NGFS notes that the data needs to improve to make these exercises more useful. In fact, that is being addressed in many jurisdictions (we’re still waiting for a final rule from the US Securities and Exchange Commission, for example), but it will take time.
You have to crawl before you walk and then run, but we’d better start running soon.
So we all need to take a deep breath and be a little patient with this process. But not too patient. The existential threat of climate change needs to be kept somewhat under the chairmanship of regulators and central banks who are dipping their toes into the waters of climate disclosure.
We should thank central banks for starting this process and improving our understanding of climate change data. But that gentle pat on the back will soon turn into a more forceful nudge from investors if data doesn’t improve and become more comparable. We don’t have decades to get it right. It is likely that we are not years old.