U.S. Federal Reserve Announces Climate Scenario Analysis Program
On September 29, 2022, the Board of Governors of the Federal Reserve System ("Fed") announced that six of the largest U.S. banks will participate in a first-of-its-kind climate scenario analysis program. The Fed will provide participating banks with "climate scenario narratives" comprising climate, economic, and financial variables that the banks will use to analyze the impact of the scenarios on specific portfolios and business strategies (and potentially on their balance sheet and overall condition). Notably, the banks will not be able to choose their own scenarios. The Fed will use the banks' analyses to encourage them to build capacity to manage climate-related financial risks and will publish aggregate-level insights it learns from the program, but not bank-specific information. The Fed will provide additional details about the program in coming months, but it is expected to launch in early 2023 and conclude around year-end. This pilot program is significant because it may be the first step in using stress testing and bank regulatory capital to address climate risks. The Fed and other regulators may begin to impose requirements on banks in future iterations of climate-related stress testing, rather than mere "encouragement."
Following the 2008 financial crisis, stress testing emerged as one of the central tools employed by U.S. bank regulators to ensure safety and soundness of financial institutions. Annual stress testing exercises, in which the Fed and other bank regulators specify macroeconomic scenarios of varying degrees of severity, drive regulatory capital levels and shareholder dividends. Banks must demonstrate that they are able to maintain certain minimum capital levels even under externally defined stress scenarios. Failure to do so can result in banks having to increase capital, withhold dividends, or both. Banks have devoted considerable resources and developed complex frameworks over the last decade to comply with these stress test requirements, including models to predict the performance of business lines and balance sheets under a severe recession.
In addition to stress test outcomes, U.S. bank regulators also assess the overall quality of a bank's stress testing framework and process. Shortcomings in that framework lead to supervisory criticisms, which may be communicated to banks without ever being published or otherwise being made publicly available. Bank regulators also conduct a "horizontal" review of stress testing frameworks in which bank capabilities are compared to one another. These reviews have led to ever-increasing supervisory standards, driving continual refinement of all banks' stress testing frameworks and capabilities towards greater sophistication.
The Fed distinguishes this climate scenario analysis from stress testing since it asserts the former will not have capital consequences and because participation in the scenario analysis was not mandatory (at least, not formally). The Fed likewise asserts that there will be no supervisory implications either. That being said, the Fed notes in the same press release that it will "engage with those [participating] firms to build capacity to manage climate-related financial risks." Presumably, it will do so in the short run through the supervisory process by "encouraging" banks to increase their ability to measure and manage climate-related financial risks.
Historically, the Fed and U.S. bank regulators have introduced similar supervisory expectations at the largest and most sophisticated banks, only to expand their scope to include other large banks over time. Likewise, the Fed and U.S. bank regulators often foreshadow new legal requirements under the initial guise of pilot programs and guidance that initially do not impose new requirements. Accordingly, banks of all sizes should follow developments closely around this initial climate scenario analysis. Other U.S. bank regulators have signaled their intent to provide guidance to banks on managing climate risk in the future.
