The Fed shares instructions on its first pilot climate scenario analysis exercise

The Federal Reserve Board (Fed) has shared instructions on its pilot climate scenario analysis exercise (CSA). Six of the largest U.S. banks, i.e., Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo are participating in the exercise and are requested to submit their results along with documentation by July 31, 2023. The analysed results and lessons learned by the Fed could inform any future CSA exercises. The Fed will publish insights gained from this CSA in Q4 2023.

Overview

The Fed aims to achieve two primary objectives with its first CSA, i) learn about the participants’ climate-risk management practices and challenges, and ii) enhance the ability of both participating banks and supervisors to identify, measure, monitor, and manage climate-related financial risks. The exercise is exploratory in nature and will not have consequences for participating banks’ capital or supervisory implications.

The CSA comprises two separate modules, a physical risk module and a transition risk module. Each module comes with a set of forward-looking scenarios that include core climate, economic and financial variables. The physical scenarios are derived from the Intergovernmental Panel on Climate Change Sixth Assessment Report’s (IPCC) Representative Concentration Pathways (RCPs) or Shared Socioeconomic Pathways (SSPs), while the transition scenarios are based on the third vintage of Network for Greening the Financial System (NGFS) Current Policies and Net Zero 2050 scenarios.

Participating banks are expected to estimate the effect of these scenarios on their loan portfolios over a one-year horizon in 2023 under the physical scenarios, and 10-year time horizon from 2023-32 under the transition scenarios. For each loan, participants are requested to calculate traditional credit risk parameters, i.e., probability of default (PD), loan given default (LGD), and, where applicable, internal risk rating grade (RRG). Rather than focusing on estimates of losses, the Fed requests participants to provide information on how the relative riskiness of exposures within their credit portfolios evolves over time in response to the different scenarios.

Banks are asked to assume that their balance sheet remains static over scenario horizons.

In addition to submitting adjusted credit parameters using standardized data templates, the participating banks need to respond to qualitative questions describing their governance, risk-management practices, measurement methodologies, results and lessons learned from the CSA.

Physical risk module

The physical risk module explores the impact of acute physical risks on the banks’ residential and commercial real estate portfolios. The physical risk scenarios consider impacts based on a distribution of potential future physical shocks with different levels of severity for both common and idiosyncratic shocks.

The common shock considers banks’ vulnerability to a severe hurricane resulting in both storm surge and precipitation-induced flooding in the Northeast region of the US (as per NCA4 classification).

For the idiosyncratic shock, banks should select a hazard event or a series of events and one of the ten NCA4 geographic regions based on materiality to their business models and exposures.

Participants should consider six iterations of physical risk shocks, three for the common shock across two degrees of physical risk severity and with different insurance assumptions, and similarly three for the idiosyncratic shock. For each of the iterations, participants should consider climate conditions broadly consistent with possible future conditions in 2050 as characterised by RCP or SSP pathways. Shocks should be applied on January 1, 2023, to the relevant asset positions held by the banks on December 31, 2022. Estimates for each credit risk parameter across the six iterations should be reported to the Fed. 

Transition risk module

The transition risk module explores the impact from transition risk drivers such as climate policies, technology development, and changing consumer and investor sentiment on traditional financials risks of banks via micro and macroeconomic transmission channels. The CSA leverages two NGFS scenarios, namely the Current Policies and Net Zero 2050, and utilises NGFS variable paths that only capture transition risks.

The Current Policies scenario, considered by the Fed as the baseline scenario, assumes increases in greenhouse gas emissions (GHG) until 2080 and an overall warming of 3oC by 2100. Here, transition risks are minimal.

The Net Zero 2050 assumes global warming is limited to 1.5oC and the world reaching net zero GHG emissions around 2050 thanks to the introduction of stringent climate policies and innovations. Transition risks are considered moderate.

Scenario projections are based on REMIND and NiGEM models. Variables from REMIND are provided on a five-year frequency (from 2020 to 2035), while for NiGEM it is on an annual basis for 2022-32. Participants are asked to estimate the impacts of the scenarios on their positions as of December 31, 2022 and should cover their wholesale (corporate and commercial real estate) credit exposures within the banking book. Banks can incorporate information about counterparties’ forward-looking transition capacity within their estimation approaches. Participating banks are asked to provide estimates of the impact of scenarios on selected counterparty specific risk parameters (PD, LGD, and RRG) for each year in the projection horizon.

Further remarks

Following other leading supervisors and central banks (the European Central Bank, the Prudential Regulation Authority/Bank of England, the French Autorite de Controle Prudentiel et de Resolution, the Bank of Japan, etc.), the Fed has introduced climate scenario analysis as a risk management and supervisory tool to evaluate climate-related financial risks the US financial system might be exposed to. The Fed considers climate risk as a potentially material risk, and as such, will continue monitoring its impact on the stability of the financial system (the Federal Reserve System five key functions). This CSA should be considered as a first iteration as it is likely to be followed by future exercises with the potential inclusion of other US financial institutions. The industry is advised to follow the developments and findings of the CSA closely and advance on its climate-risk management practices. Mazars provides support in climate-related and environmental financial risk management and modelling.

Reference:

Federal Reserve Board – Federal Reserve Board provides additional details on how its pilot climate scenario analysis exercise will be conducted and the information on risk management practices that will be gathered over the course of the exercise