According to a recent study, over the past 20 years, climate change has cost the world $2.8T, or $16.3MM per hour. Of the damage caused by climate change, 64% was connected with storms, 16% with heatwaves, and 10% for each floods and droughts. It is therefore not surprising that regulators, investors, and the wider market are increasingly focusing on how financial institutions understand and plan to respond to the potential business impact posed by climate risk.The Federal Reserve recently published the results of its pilot climate scenario analysis — a study conducted in 2023 among six of the largest banks — to “learn about large banking organizations’ climate risk-management practices and challenges and to enhance the ability of large banking organizations and supervisors to identify, estimate, monitor, and manage climate-related financial risks.” We originally discussed the scenarios the Fed was using to assess those large banks last year and are pleased to bring you the results.Overview of the Pilot Climate Scenario AnalysisThe pilot looked at two types of climate risk drivers: physical risk and transition risk. Physical risk stems from the direct impact of acute climate events such as hurricanes, floods, droughts, and wildfires, as well as from chronic events, such as higher temperatures, the rise in sea levels, and environmental degradation. Transition risk arises from the shift in policy, consumer and market sentiment, technology, and regulation associated with a move towards a low-carbon economy.The effects of these drivers were modeled on four types of risk affecting financial institutions:
- Credit risk — probability of loan default and collateral values
- Market risk — repricing of financial instrume11nts and fire sales
- Operational risk — business disruptions and legal and liability risk
- Liquidity risk — high-quality liquid asset demand and refinancing risk
Participating banks took different approaches to the pilot climate scenario analysis, depending on their individual business models, views on risk, and access to data. Overall, the exercise highlighted the following points:
- Significant data gaps and modeling challenges led many participants to rely on external vendors to fill the gaps.
- An understanding of insurance market dynamics emerged as crucial.
- Design choices — including shock scope, scenario severity, starting points, insurance assumptions, and balance sheet assumptions — significantly influenced the outcome of the exercise.
- Highly uncertain aspects of the climate-related risks (e.g. timing and magnitude) made it hard to incorporate them into risk management frameworks on a routine basis.
What This Means for Smaller Institutions While this pilot program focused on the six largest banks in the US, community financial institutions (CFIs) should be aware of the results of this pilot. Another touch point for your institution to consider is Supervisory and Regulatory (SR) Letter 23-9, entitled “Principles for Climate-Related Financial Risk Management for Large Financial Institutions”. As the title indicates, this regulatory guidance applies to institutions with more than $100B in assets, so there is no direct regulatory requirement for smaller institutions. Nevertheless, as the regulatory schema begins to take form in the area of climate risk, your institution should take notice. Below are four areas to begin thinking about:
- Integrate climate risk management into existing frameworks. Drawing from the methodologies used in the climate scenario analysis, institutions should consider integrating climate risk analysis into their existing risk management frameworks. This includes identifying regions and sectors within your lending portfolios that are particularly susceptible to adverse climate events and conducting stress testing to evaluate the impact of such an event on your financial position. For example, CFIs in the Midwest with high agricultural loan concentrations are especially vulnerable to flooding and droughts, which could impair their customers’ ability to repay loans and potentially lower the value of their collateral.
- Collect and analyze data. The data challenges encountered by the larger banks during last year’s pilot suggest it is worth starting the process early. Information relating to real estate exposures (size, location, age, etc.), insurance, obligor’s transition risk, and infrastructure can be captured from clients and integrated with data from third-party vendors where necessary. Climate data, such as weather patterns, flood maps, and carbon emission forecasts will also be required. Consider using external experts or climate risk analytics tools.
- Finetune lending and investment strategies. Where possible, consider diversifying your portfolio to reduce exposure to sectors and regions that are likely to be heavily impacted by climate events. Financial institutions operating at a local level may limit risk by leveraging data at their disposal to provide better pricing of credit risk. What’s more, research suggests that CFIs can help ease credit constraints following a natural disaster by offering corporate recovery loans to affected businesses. Promoting green financing products can also help mitigate risk, while also meeting environmental goals.
- Engage with the community. There are many ways in which CFIs can help their communities limit climate risk. They can provide their clients with educational resources on sustainable practices and support their transition efforts with green loans. They can also collaborate with local government, businesses, and industry groups to promote climate resilience initiatives. This could include funding for community infrastructure projects that mitigate risk.
Although there is currently no regulatory requirement for CFIs to conduct any climate-related risk assessment or adopt any of the measures contained within the climate scenario analysis pilot or SR Letter 23-9, taking a proactive approach to climate risk will only help you prepare, if there are requirements down the line. By identifying risks, collecting the data necessary to conduct scenario analysis, and taking steps to mitigate climate risk, CFIs can contribute to the overall resilience of the financial system and their local communities in the face of climate change.
