With regulators keeping close watch, the results underscore the need for ongoing climate risk management investment and adaptation within the financial sector.

On May 9, 2024, the Board of Governors of the Federal Reserve System (FRB) published summary results of a pilot climate scenario analysis (CSA) that explored how resilient six of the largest US bank holding companies (by total assets) are to climate-related financial risks. The analysis is intended to help the FRB “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.”

The CSA was first announced in September 2022, and was intended as an exploratory exercise. It does not therefore result in any capital or supervisory consequences for the participating financial institutions.

Framework for the Pilot CSA

The CSA consisted of two independent modules, reflecting the two main categories of risk associated with climate change:

1. Physical risk: the harm to people and property arising from acute, climate-related events, such as hurricanes, wildfires, floods, heatwaves, and droughts as well as longer-term chronic phenomena, such as higher average temperatures, changes in precipitation patterns, sea level rise, and ocean acidification.
2. Transition risk: stresses to certain institutions, sectors, or regions arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes that would be part of a transition to a lower carbon economy.

Participants took different approaches to construct the risk scenarios and estimate resultant damages, “driven largely by participants’ business models, views on risk, access to data, and prior participation in climate scenario analysis exercises in foreign jurisdictions.”

Participants estimated the effects of the scenarios on a subset of the credit exposures in their loan portfolios (e.g., commercial real estate and residential real estate), and assessed potential vulnerabilities across short- and longer-term time horizons.

According to the FRB, the microprudential risks ultimately implicated by climate risk drivers include:

• Credit risk: higher probability of default or loss given default; collateral values
• Market risk: repricing of financial instruments; fire sales
• Operational risk: business disruptions; legal and liability risk
• Liquidity risk: high-quality liquid asset demand; refinancing risk

According to the FRB’s review of participants’ governance and risk management practices as used in the pilot CSA, all participants used or adapted existing governance, risk-management, and internal controls for the pilot CSA exercise, while most created a working group or council (responsible for overseeing the conceptual design and execution of the pilot CSA exercise) reporting into an existing climate risk committee or a management-level risk committee.

Participating financial institutions were required to gather and report qualitative and quantitative data to the FRB, which the agency used to draw conclusions.

Key Insights and Findings

In general, participants in the CSA:

• faced significant data and modelling challenges as they conducted the exercise, (including issues related to comprehensive and consistent data and model availability), leading many to source data and models from third-party vendors or public sources to fill gaps;

• considered indirect effects and chronic risks;
• noted the importance of understanding insurance market dynamics when modeling the effects of physical risk hazards on credit exposures; 
• found that scenario design choices (including scope of shock, scenario severity, starting points, insurance assumptions, and balance sheet assumptions) affected their approaches, estimates, and results; and
• expressed difficulty in measuring highly uncertain aspects of climate-related risks (e.g., timing and magnitude), making it challenging to incorporate them into risk management frameworks.

Conclusion

The pilot CSA is another link in the Biden administration’s program to address and mitigate climate risk in general, and climate-related financial risk to the US economy in particular. It follows the federal banking agencies’ October 2023 joint Principles for Climate-Related Financial Risk Management for Large Financial Institutions, providing  large financial institutions with a framework for understanding and managing exposures to climate-related financial risks (for more information, see this Latham blog post).

The results of the pilot CSA provide valuable insights into the approaches six of the largest US bank holding companies are taking — and the challenges they are facing — to identify, estimate, monitor, and manage climate-related financial risks. It reveals that while banks are employing climate scenario analysis to assess the resilience of their business models and identify potential vulnerabilities, they face significant challenges due to data gaps and the inherent uncertainties of climate-related risks.

The insights from the pilot CSA exercise will prove valuable for banks and banking regulators. “Drawing on lessons learned from the exercise,” the FRB noted, it “will continue to engage with participating banks regarding their capacity to measure and manage climate-related financial risks.” To the extent that the FRB is focused on tackling climate-related financial risks in the US economy, climate risk management, governance, and compliance will increasingly become a priority for financial institutions of all sizes.

Latham & Watkins will continue to monitor developments in this area.