Last week, the Federal Reserve announced the first-of-its-kind stress test for Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo “designed to enhance the ability of supervisors and firms to measure and manage climate-related financial risks.” Technically, the Fed is calling this a “scenario analysis” and emphasized that:
Climate scenario analysis is distinct and separate from bank stress tests. The Board’s stress tests are designed to assess whether large banks have enough capital to continue lending to households and businesses during a severe recession. The climate scenario analysis exercise, on the other hand, is exploratory in nature and does not have capital consequences. By considering a range of possible future climate pathways and associated economic and financial developments, scenario analysis can assist firms and supervisors in understanding how climate-related financial risks may manifest and differ from historical experience.
Details on what the climate scenario involves are still in development:
The pilot exercise will be launched in early 2023 and is expected to conclude around the end of the year. At the beginning of the exercise, the Board will publish details of the climate, economic, and financial variables that make up the climate scenario narratives.
Our take: This is an interesting development that could have a multitude of implications around the concept of financial materiality and risk scenarios aligned with the SEC’s climate disclosure proposal. The most obvious financial exposures the banks have are loans for properties in hurricane- and flood-prone areas, most of which are likely backed up with insurance to reduce financial losses. What I think will be more fascinating is to see transition risk and exposures. These may illustrate the extent of bank activity in financing net-zero activities, which could possibly be inconsistent with much of the banks’ advertising and public messaging about their commitments.
In other words, the results of the scenario analysis could potentially lead to greenwashing enforcement actions by the government. Of course, we will be watching this as it develops.