Fed looks into climate regulation

Six notable U.S. banks will participate in a pilot exercise to analyse the impacts of climate change on bank operations and exposures under various scenarios, the Federal Reserve (Fed) stated last week. It is hoped that the exercise would eventually improve bank credit profiles to the degree that it reveals holes in banks’ data collection and risk governance and increases the United States’ regulatory competency around systemic climate risks, which has lagged other developed markets.

Although the Fed has disregarded capital or supervisory implications and has carefully defined the pilot as an exploratory “scenario analysis” rather than a “stress test,” the exercise signals a promotion of climate risk to a higher priority ranking on the regulatory agenda. Although the Fed did not disclose specifics regarding the intended strategy, regulators in Canada, the EU, the U.K., France, and Hong Kong have already conducted or are planning to conduct comparable exercises. Exercise options include “top-down” modelling of physical and economic effects, “bottom-up” estimates of how climate change will affect specific borrowers, or a hybrid.

Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo are among the companies participating in the exercise. The exercise begins in early 2023 and is anticipated to wrap up by the end of the year. Specifics of the climate, economic, and financial assumptions won’t be made public until it kicks off. The physical hazards associated with increased frequency and severity of weather events as well as the risks associated with the transition to a clean economy, including the implementation of carbon pricing, are some of the aspects expected to be covered.

Although firm-specific results won’t be made public, aggregate findings and insights from the exercise, which may not be available until 2024, will be used to customise future regulations. The project is anticipated to establish climate scenario research as a crucial instrument in bank risk management frameworks, similar to other markets. The exercise’s timing and potential regulatory repercussions are unknown. But earlier this month, Fed Vice Chair for Supervision Michael Barr said the Fed would collaborate with the FDIC and OCC to create standards for managing climate risks for large banks, in an effort to lessen the vulnerability of institutions to long-term climate shocks.

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