The US Federal Reserve is starting a climate change experiment on major banks

The US Federal Reserve is conducting its first climate change experiment.

The central bank this month announced details of how it will conduct a “pilot climate scenario analysis exercise” involving the six largest US banks: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo.

The Fed actually wants major banks to game out how they will handle climate change-related shocks. For example, what will happen to real estate holdings in the northeastern United States during hurricane season when sea levels are higher? These scenarios are grouped together in training as “physical risks.”

Then there is “transition risk”: How will financial institutions deal with the wholesale shift from fossil fuels to cleaner energy? What will happen to investments in coal mines or gas plants? How to make loans when customers refuse to do business with a huge impact on the climate?

This is a very important question, not only for banks, but for everyone. How banks manage, or fail to manage, climate risk will affect things like home loans, business loans, retirement accounts, and insurance — things that will touch every sector of the economy. The Fed has set a deadline to receive the report from the bank at the beginning of August.

Given the hugely expensive climate disasters around the world in recent years and the massive economic disruption of future warming, it makes sense that the U.S. central bank would want financial institutions to understand how they are affected. By 2022, the US will experience 18 disasters in which losses exceed $1 billion.

“The Fed has a narrow, but important, responsibility regarding climate-related financial risks – to ensure that banks understand and manage material risks, including financial risks from climate change,” said Fed oversight vice chairman Michael Barr. , in a statement last week.

Other arms of the government are also looking into climate-related financial risks. In 2021, President Joe Biden issued an executive order directing federal agencies to quantify the threat and disclose it.

Image Sean Gallup/Getty

But the Fed’s core mission is to keep employment and inflation down, and its main lever is to set interest rates, which doesn’t leave much room to do anything about the climate.

Earlier this month, Powell categorically distanced the Fed’s activities from climate change. “We are not, and will never be, ‘climate policy makers,'” he said at a conference in Sweden. The US dollar is also the world’s dominant reserve currency, so small changes in monetary policy in the US can ripple across the world. Banks, governments, and journalists await the announcement from the Fed and carefully parse every word from Powell as if it were a vague economic forecast. As a result, the Fed is very careful about what it says and does. The Fed declined to comment on the record.

So how does the Fed use the results of this climate scenario analysis? It probably won’t be a tool to inform monetary policy, but it could be a signal to banks that the risks of climate change could be greater than they think and they need to prepare now.

How to run a climate experiment in a bank

The Fed is careful to note that climate scenario analysis is different from stress testing. In Fed-speak, a stress test measures whether a bank has enough money to meet its obligations during tough economic times. The Fed can then use the results to set new rules or adjust policies.

Climate scenario analysis, by contrast, is more of a storytelling exercise. One path envisions a world with no new climate policy between now and 2050, allowing current economic trends to continue. Others chalk out a path to net-zero greenhouse gas emissions by mid-century. The Fed builds on climate models developed by the Intergovernmental Panel on Climate Change (IPCC) and financial models from the Network of Central Banks and Supervisors for Greening the Financial System (NGFS).

In both worlds, banks then have to figure out how their loan portfolios will respond to these physical and transition risks.

Board of Governors of the Federal Reserve System

This is a new type of analysis for the Fed, and it’s one of the most complex: Take all the complexities of sea-level rise, melting ice, feedback scenarios, and extreme weather and marry it with the complexities of business cycles, consumer confidence. , real estate trends, and innovation. From there, think about whether your bank will have enough cash to cover losses and lend to customers whether or not the world does or doesn’t do its part on climate change.

There is a lot to process, and not every variable will be captured, so one of the main goals of this exercise is just to find out what to do to run a better version of this analysis in the future.

“This is a pilot program so learning is really the goal of the program,” said Jiro Yoshida, a business professor at Pennsylvania State University, who studies macroeconomics, risk, and climate change.

The Fed says climate change is outside its wheelhouse. Activists and economists say they can do more.

Even though the Fed is the most important central bank in the global economy, it is late for this type of exercise. Other central banks, including the Bank of England and the Bank of Japan, have conducted their own climate studies. The European Central Bank is conducting a real stress test.

Part of the difficulty for US monetary policy is that the Fed is more limited in its delivery than other central banks. “I see an analogy between Western medicine and Japanese medicine,” says Yoshida. “Western medicine targets specific symptoms, such as aspirin for fever and pain. Japanese medicine is more of a combination of many ingredients that deal with many symptoms at the same time.

The Bank of Japan, for example, is creating tools to reward banks that are better prepared to deal with climate chaos and stimulus that isn’t. It is actively working with policy makers and local governments to help mitigate these risks. The Fed, on the other hand, prides itself on its independence from political and monetary policy siloes from fiscal policy, leaving the latter to the legislature. Environmental activists have called on the Fed to clearly factor climate change into its decisions, but the central bank has resisted.

“We must ‘stick to knit us’ and not wander off to pursue perceived social benefits that are not tightly linked to our statutory goals and authorities,” Powell said earlier this month. “Creating new goals, however worthy, without a clear statutory mandate would undermine our case for liberty.”

Drew Angerer/Getty Images

Yoshida says it’s not clear which approach is better for dealing with the financial impact of climate change, but it could theoretically reduce the risk if it’s known.

Climate scenario analysis can help inform such policy, but the Fed’s current version has some major limitations. It examines banks individually rather than assessing their associated risks. Massive floods can inundate thousands of homes, for example, causing huge losses and cash shortages in many banks at once. Unable to borrow money from each other, banks must turn to the Fed. Some economists have warned that the cumulative effects of climate change could lead to the next major financial crisis.

“How much will you learn about risk management practices and challenges if you don’t take risks well?” said Anne Perrault, climate finance policy advisor at Public Citizen.

The worry is that a positive result from an incomplete test can give banks or regulators false security. The Fed should emphasize that there is a lot of uncertainty about these risks and that banks should err on the side of caution, according to Perrault.

For its part, the Fed acknowledged that the experiment was not comprehensive. “These issues challenge existing risk management and supervisory approaches and lead to a high level of uncertainty about the potential implications of climate risk drivers for large banking organizations,” according to the climate scenario analysis.

But the fact that the Fed sees this tells all financial institutions, not just the six examined in this analysis, that they cannot ignore the effects of climate change on their operations.

“It’s the beginning. This puts the banks on notice that the Fed cares about financial risk,” said Perrault. “The problem is how people perceive it.”