United States: Federal Reserve Continues Research On Climate Risk

On April 7, 2023, the Federal Reserve Bank of New York (FRBNY) released two staff reports on climate-related risks for financial institutions. The first report discusses US banks' exposures to transition risks from climate change.¹ The second discusses the design of climate stress tests done to assess and manage macroprudential risks from climate change in the financial sector.²

While the staff reports do not suggest or impose legal requirements, they provide financial institutions with insights on banking regulators' positions on climate-related risk management requirements and current industry practices. In this Legal Update, we summarize the key points of the reports and consider how regulators might use them as they develop climate-risk management expectations for financial institutions.

Transition Risk Exposure

The U.S. Banks' Exposures to Climate Transition Risks report analyzes how banks may be affected by policies and scenarios designed to promote the transition to a low-carbon economy (in contrast to bank exposure to the physical risks associated with climate change). The FRBNY uses loan-level data from the commercial lending portfolios of larger financial institutions combined with general sectoral estimates to estimate bank exposure to transition policies and scenarios under three models. It finds significant variation in bank exposures based on different models used, but, even despite the variation, while banks' exposures to transition risks are significant, they are not very large—no higher than 16 percent of their loan portfolio even in the most severe scenario. There is also evidence that many banks have exited from lending to industries at the highest risk of being adversely impacted by a transition to a low-carbon economy, which may be driven by banks' attempts to reduce their exposures to climate transition risks.

The report suggests the need for additional research on the nexus between financial stability and climate risks. It recommends that regulators analyze how borrowers' exposure to climate risks will impact their access to funding going forward, whether their credit profile fully reflects these risks, and where instruments related to climate risk are in the financial system may also be helpful.

Stress Testing Report

The Climate Stress Testing report assesses the potential for banks to conduct stress testing to manage climate-related risks to financial stability. It identifies physical risk (i.e., the risk to economic activity from physical manifestations of climate change) and transition risk (i.e., the effects on economic activity from regulatory interventions in response to climate risk) as the types of climate change risk that could impact economic activity. Since transition risks result from the dynamic decisions of policymakers who consider costs and benefits while considering political feasibility, the economists argue that additional research on political economy considerations would be helpful in defining more plausible transition risk scenarios. The economists also call for deeper analysis of the interactions between climate change and the overall economy to better model the economic environment that accompanies physical climate risk realizations. The report suggests that while existing research indicates that climate risks are already priced across asset classes, it is unknown whether the risks are adequately priced (i.e., how quickly investors may update beliefs in response to information about future climate risk realizations). Overall, the Climate Stress Testing report concludes that additional research is required to identify better models and data, which suggests that the Federal Reserve may still be far from using climate stress testing to set capital requirements.

Conclusion

The U.S. Banks' Exposure to Climate Transition Risks report looks at a narrow slice of the banking sector (commercial loans by larger banks) and seems to find that the level of transition risk may be both manageable and declining. We expect this data point may be used to further support the view that the banking industry has begun to understand and manage climate-related financial risk. Accordingly, it may be unnecessary for regulators to impose more proscriptive requirements.

The Climate Stress Testing report is more descriptive than determinative and illustrates the highly academic nature of much of climate stress testing. It recognizes that climate stress testing is still in its early days and, therefore, supports the view that climate stress testing should not be used to set capital requirements.³

Footnotes

1. FRBNY, U.S. Banks' Exposures to Climate Transition Risks (Apr. 2023), https://www.newyorkfed.org/research/staff_reports/sr1058.html.

2. FRBNY, Climate Stress Testing (Apr. 2023), https://www.newyorkfed.org/research/staff_reports/sr1059.html.

3. See our Legal Update on the Federal Reserve's recent climate scenario analysis exercise, which does not set capital requirements.

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