Fed urges caution in wake of Silicon Valley collapse, so what about climate?

May 18, 2023|Written by and |Federal Reserve

The Federal Reserve’s recent postmortem of the failure of Silicon Valley Bank offers painfully relevant lessons and recommendations for its response to climate change-related financial risks.

Among the important lessons offered by Michael Barr, vice chair for supervision who led the review, were that models and accounting approaches matter, threats to financial stability aren’t always from the largest banks, and capital is important.

Perhaps the most important lesson, however, relates to how the Fed – and particularly chair Jerome Powell – approaches financial regulation. The report’s big take-home lesson on this point? Regulators and bank managers must be more willing to bring a “precautionary perspective” to risk, and err on the side of caution when it comes to potential threats that could topple the entire financial system. Climate change is just such a threat.

‘Not contemplated by the Fed’

On SVB’s modeling, the review concluded that false assumptions were included in its interest rate risk models that left it inattentive to its risk, including the key assumption that deposits would be available when needed. Its accounting practices similarly allowed risks to be masked, letting SVB hide that the fact that its long-term government bonds were rapidly losing value as interest rates were rising.

On regional bank failure as a systemic threat, Barr indicated the possibility was just “not contemplated by the Fed”. SVB’s failure due to concentrated risks – risks that were tied to it serving a particular market in a particular place – triggered panic among depositors at other institutions. The review determined that a firm’s distress may have systemic consequences through contagion, where concerns about one firm spread to others, even if the first firm is not “extremely large, highly connected to other financial counterparties, or involved in critical financial services”.

On capital adequacy, Barr observed that “while the proximate cause of SVB’s failure was a liquidity run, the underlying issue was concern about its solvency.” SVB simply didn’t have the loss-absorbing capacity it needed when its startup and venture-capital customers pulled their deposits. Underscoring this point, he declared that “strong capital matters”.

The report found that SVB’s board and management produced a “textbook case of mismanagement by the bank”. and Fed supervisors failed to respond quickly and forcefully enough. But it ultimately pinned many of these shortcomings to an even more fundamental “shift in the stance of supervisory policy” that “impeded effective supervision” by “reducing standards, increasing complexity, and promoting a less assertive supervisory approach”.

Although the report did not explicitly acknowledge it, this shift had clear links to Powell. Powell’s support for Trump-led deregulation – including reducing compliance requirements for SVB-sized banks through “tailoring”, weakening of the “matters requiring attention” supervisory tool, and gutting the Volcker rule – represented a shortsighted, deferential-to-industry approach to responding to potential financial stability threat.

In response to concerns identified in the report, Barr embraced a need for a “precautionary perspective”, and for bankers and supervisors to “be humble” about their “ability… to predict how losses might be incurred, how a future financial crisis might unfold”, and “the effect of a financial crisis… on the financial system and our broader economy”. He also acknowledged the need for greater resilience “against the risks that we may not fully appreciate today”.

In short: the Fed let a plain-to-see risk transform into a hard-to-address impact.

Lessons for climate-related risk

Unfortunately the Fed is poised to repeat its mistakes with climate risk, with much greater potential consequences. On each of the report findings mentioned above, as well as others, there are obvious lessons for responding to climate-related risk.

One is the need to stop relying on bad modeling. For its pilot climate scenario analysis exercise, the Fed is using integrated assessment models (IAMs) with assumptions that beggar belief. As one expert observed on the Network for Greening the Financial System models being used by the Fed: “The NGFS scenarios would have us believe that, in a ‘business-as-usual world’ heading to 3°C warming, global GDP in 2050 would be only around 4% lower (implying a loss of less than two years’ growth) than in a world where we have achieved net-zero emissions and kept warming within 1.5°C. No wonder central banks foresee only modest financial losses.”

On the use of IAMs for estimating risk generally, noted economists have observed that “they have very little value” and “fail to provide much in the way of useful guidance.” These experts and others have suggested that, rather than rely on such flawed models, we should instead act on the overwhelming evidence that a financial system pushing us past a 1.5°C target would be devastating for both the world and that system.

A likely fruitful approach would be to consider narrative, common-sense scenarios of severe, realistically possible climate-related risks and assess their potential impact on banks and the financial system in order to develop mitigation measures to be taken now. For example, the Fed could consider the possible effects on banks and the financial system of massive physical climate harms which could occur on short and long timeframes; a sudden collapse in coastal real estate prices; and “Minsky moments” that ignite widespread fire sales of fossil-fuel assets.

Similar to poor modeling by banks and supervisors, current accounting rules allow assumptions that are at odds with climate realities. As a result, banks invested in climate-impacted areas may be able to avoid recognising the effect of unpriced risk on their portfolios.

A ‘systemic crisis in slow motion’

The concentrated risks SVB faced likely pale in comparison to those of regional and community banks, credit unions, and municipalities in climate hotspot areas as climate change facilitates the Fed staff-recognised “flow of risk” to these institutions. As scores of insurers fail in or flee from Louisiana, Florida, California, Texas and elsewhere, and residents struggle to pay mortgages and farm bills, financial and municipal entities will experience significant subsystemic shocks that could represent a “systemic crisis in slow motion”.

Contagion, in the context of climate change, could occur in this and other ways not currently contemplated by the Fed.

It’s likely that the largest US banks financing the fossil fuel industry also won’t have the equity they need if the quickly evolving shift to renewables suddenly strands those fossil assets. A New York Fed study determined that, under an abrupt but plausible correction in asset prices due to the transition, the aggregate expected capital shortfall of the top four US banks would be significant. Climate risks for these and other banks remain woefully under-reflected in capital requirements.

The precautionary principle underscores a need for action in the face of uncertainty and threats of serious or irreversible damage. Barr recognised a need for a precautionary perspective in the context of interest rate risks that are far more certain and reversible than the risks posed by climate change.

Climate risks are radically uncertain, and uniquely irreversible, far-reaching and significant. One of the most responsive and effective risk management measures is to supervise a transition as rapid and orderly as possible from the greenhouse gas emitting activities that inflate both physical and transition risk.

Rather than act out of precaution, Powell has slow-walked responses to climate-related risk and only begrudgingly accepted their relevance to the Fed’s mission.

Other Fed governors, like Christopher Waller, have been even more dismissive. Embracing a style of climate denial that is increasingly common among conservative US policymakers, Waller recently stated that, although “climate change is real,” he “do[es] not believe it poses a serious risk to the safety and soundness of large banks or the financial stability of the United States”.

The financial system likely will recover from Powell’s failed leadership on SVB. All bets are off, however, if the Fed continues to tred the same path on climate-related risk.

This page was last updated July 4, 2024

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