What to expect from the Fed’s climate scenario analysis

The Federal Reserve has announced its intention to carry out an inaugural climate scenario analysis, aimed at assessing long-term, climate-related financial risks facing the largest banks in the US.

The exercise will be conducted on a pilot basis beginning early next year and, although the Fed will not release further details on the scenarios it will use until the launch, official statements have revealed certain information about its plans.

No capital consequences, for now

In a statement published last week, the Fed drew a distinction between the upcoming exercise and the stress tests it conducts on a routine basis. It said its stress tests are designed to assess whether large banks have enough capital to continue lending to households and businesses during a severe recession. It stated the climate scenario analysis exercise, on the other hand, is exploratory in nature and does not have capital consequences.

Despite the Fed’s claim that the upcoming analysis has no relevance to its capital rules, observers have predicted that future exercises will ultimately have regulatory implications. Speaking last year, JPMorgan CEO Jamie Dimon suggested the Fed will eventually carry out a fully-fledged climate stress test.

“When they figure out what they really want to stress test and it’s really real, they probably will appoint capital,” he said.

The Fed may follow in the footsteps of the Bank of England (BoE), which carried out its first climate biennial exploratory scenario exercise in 2021 and has subsequently announced a review of the interactions between climate change and its capital regime. Although it has not used the scenario analysis to set capital requirements directly, it says the exercise “will help to determine whether system-wide capital levels provide a sufficient level of resilience against climate risks”. The BoE is hosting a research conference on the subject later this month.

The Fed has announced a separate review of its capital regime to understand how it is supporting the resilience of the financial system, although it has not yet explicitly linked this to the risks posed by climate change.

Results could inform upcoming guidance

The Fed’s scenario analysis could be used to inform new guidance for the management of climate-related risks, currently being developed by US banking regulators. The Office for the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) are both finalising principles following consultation exercises earlier this year. FDIC chair Martin Gruenberg said the principles represent an initial step, and that the FDIC will work on an interagency basis with the OCC and Federal Reserve to provide further guidance for climate-risk management.

Gruenberg said the draft principles are intended to support the use of scenario analysis. He has previously touted the importance of both top-down exercises led by regulatory agencies and bottom-up participation by individual firms.

Phillip Basil, director of banking policy at Better Markets, urged the Fed to expand its scenario analysis to include all the large banks that are part of the annual supervisory stress test, and to incorporate climate risks into its routine exams.

“The Fed and other federal banking agencies must incorporate identified climate-related financial risks into banks’ overall supervisory assessments and ratings to ensure the banks are addressing the risks instead of merely pointing them out, something they have failed to do, at least publicly,” he said.

Only high-level insights to be published

The Fed has said it does not intend to release firm-specific information based on the exercise but expects to publish insights at an aggregate level at some point during 2024. The BoE and European Central Bank have adopted similar approaches following their own initiatives, providing participating institutions with individual feedback, and instructions to take action where necessary.

“Over the course of the pilot, participating firms will analyse the impact of the scenarios on specific portfolios and business strategies,” said the Fed’s statement announcing the project. “The Fed will then review firm analysis and engage with those firms to build capacity to manage climate-related financial risks.”