The US Federal Reserve begins experimenting with climate change on the big banks

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

This month, the Central Bank announced details of how to conduct “Experimental exercise for climate scenario analysisIt includes the six largest US banks: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.

The Fed basically wants the big banks to tinker with how they deal with shocks related to climate change. For example, what will happen to their real estate holdings in the Northeastern United States in a future hurricane when sea levels are higher? These scenarios are grouped together in the exercise as Physical Hazards.

Then there’s the “transition risk”: how will financial institutions handle a sweeping shift away from fossil fuels toward cleaner energy? What will happen to their investments in coal mines or gas plants? How will loans perform when customers move away from businesses that have a significant impact on the climate?

These are extremely important questions, not just for banks, but for everyone. How banks manage, or fail to manage, climate risks will affect things like home loans, business lending, retirement accounts, and insurance — things that will touch every sector of the economy. The Fed has set a deadline for receiving these reports from banks by the beginning of August.

according to Unusually expensive wave of Disasters exacerbated by climate With the world in recent years and the far-reaching economic turmoil of warming in the future, it stands to reason that the US central bank would want financial institutions to know how this would affect them. In the year 2022, the United States will suffer 18 disasters Losses exceeded 1 billion dollars.

“The Fed has narrow, but important, responsibilities in relation to climate-related financial risks — to ensure that banks understand and manage their material risks, including financial risks from climate change,” said Fed Vice Chairman of Oversight Michael Barr. in the current situation last week.

Other arms of government are also examining climate-related financial risks. In 2021, President Joe Biden executive order Directing federal agencies to screen for and detect these threats.

President Joe Biden speaks at the COP27 international climate conference on November 11, 2022 in Sharm El-Sheikh, Egypt.

President Joe Biden signed an executive order in 2021 directing federal regulators to assess the financial risks of climate change.
Sean Gallup / Getty Images

But the Fed’s primary job is to keep employment high and inflation low, and its main lever is setting interest rates, which doesn’t give it much room to do anything about the climate.

Earlier this month, Powell explicitly distanced the Fed’s activities from climate change. He said in a conference in Sweden. The US dollar is also the world’s dollar the dominant reserve currency, So small changes in monetary policy in the United States can spread around the world. Banks, governments and journalists await announcements from the Federal Reserve and carefully analyze every word from Powell as if he were some mysterious oracle of economics. As a result, the Fed is very careful about what it says and does. The Fed declined to comment on the record.

So how will the Fed use the results of this climate scenario analysis? It probably won’t serve as a tool to inform monetary policy, but it could serve as a signal to banks that the risks of climate change may be greater than they realize and that they should start preparing now.

How to conduct a climate experiment on a bank

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

By contrast, climate scenario analysis is more than a storytelling exercise. One path imagines a world in which there are no new climate policies between now and 2050, allowing current economic trends to continue. The other draws the path to net greenhouse gas emissions By the middle of the 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 to Green the Financial System (NGFS).

In both worlds, banks will then have to figure out how their loan portfolios respond to the physical and translational risks mentioned above.

Graph showing the risks assessed in the empirical climate scenario analysis exercise.

A figure from the Fed’s empirical climate scenario analysis showing how climate risks translate into financial risks.
Board of Governors of the Federal Reserve System

This is a new kind 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 severe weather, and marry that with the complexities of business cycles, consumer confidence, real estate trends, and innovation. From there, find out if your bank will have enough money to cover its losses and lend to customers whether or not the world works together on climate change.

It’s a lot of process, and not every variable will be recorded, so one of the main goals of this exercise is simply to learn what it takes to run a better version of this analysis in the future.

“This is an experimental program, so learning is really the purpose of the program,” he said. Jiro Yoshidaprofessor of business administration at Penn State University, who studies macroeconomics, risk, and climate change.

The Fed says climate change is outside its cockpit. Activists and economists say it can do a lot.

Although the Fed is the most important central bank in the global economy, it is late to this type of exercise. Other central banks, incl Bank of England and the Bank of JapanThey’ve already done their climate studies. the European Central Bank They did actual stress tests.

Part of the difficulty with US monetary policy is that the Federal Reserve is more limited in its powers than other central banks. “I see similarities between Western medicine and Japanese medicine,” Yoshida said. Western medicine targets specific symptoms, such as aspirin to treat fever and pain. Japanese medicine is a combination of many ingredients that deal with many symptoms at the same time.”

For example, the Bank of Japan is creating tools to reward banks that are better equipped to deal with climate chaos and to incentivize banks that are not equipped. It works explicitly with policy makers and local governments to help mitigate these risks. On the other hand, the Fed prides itself on its independence from policy and monetary policy is isolated from fiscal policy, leaving the latter to the legislators. Environmental activists called the Fed outright Climate change factor in decision makingbut the central bank was resisting.

We should ‘hold on to our knitting’ and not wander about in pursuit of perceived social benefits that are not intimately connected to our legal goals and powers,” Powell said. earlier this month. “To take on new aims, however worthy they may be, without a clear legal mandate would undermine the cause for our independence.”

Climate activists rally outside the Federal Reserve Building on October 29, 2021, in Washington, DC.

Activists have criticized Fed Chairman Jerome Powell for lack of action on climate change.
Drew Angerer/Getty Images

It’s not clear which approach is best for dealing with the financial impacts of climate change, Yoshida said, but either could theoretically work to reduce risks if they’re well informed.

Climate scenario analysis can help guide these policies, but the Fed’s current version has some major limitations. It examines banks individually rather than assessing interrelated risks. A major flood could flood thousands of homes, for example, resulting in huge losses and cash shortages in many banks at the same time. Unable to borrow money from each other, banks will have to Turn to the Fed. Some economists have warned that the simultaneous effects of climate change could lead to outbreaks The next major financial crisis.

“How much will you learn about risk management practices and challenges if you don’t handle risk well?” He said Ann Perraultclimate finance policy advisor at Public Citizen.

The concern is that a positive result from an incomplete test could give the bank or regulators a false sense of security. The Fed should emphasize that there is a great deal of uncertainty around these risks and that banks should take a side of caution, according to Perrault.

For its part, the Fed acknowledged that the experiment is not comprehensive. According to the climate scenario analysis, “these issues challenge existing approaches to risk management and supervision and create a high degree of uncertainty around the potential impacts of climate risk drivers on large banking institutions.”

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

“It’s a start. It puts banks on notice, the Fed cares about financial risks,” Perrault said. “The problem is how people will perceive that.”

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