New York Fed researchers develop climate stress test for banks

September 24, 2021

(Reuters) – Researchers at the New York Federal Reserve Bank have developed an approach to measuring banks’ exposures to climate-related risks, a possible early step toward assessing whether financial institutions have enough capital on hand to withstand them.

The publication Friday of a paper describing the new methodology may mark an early step toward an eventual “climate stress test” for U.S. banks. It’s an approach already used by other global central banks but that has drawn intense criticism from U.S. Republican lawmakers who say that monitoring for such risk goes beyond the central bank’s remit.

Fed Chair Jerome Powell for his part has said he believes that making sure banks are resilient to the threat of climate change is squarely within the Fed’s mandate.

Friday’s paper, titled simply “Climate Stress Testing,” outlines for the first time exactly how the Fed could go about checking the vulnerability of banks and the financial system broadly to shocks as the nation moves to limit emissions of heat-trapping carbon dioxide.

“Banks that provide financing to fossil fuel firms are expected to suffer when the default risk of their loan portfolios increases, as economies transition into a lower-carbon environment,” the researchers said. “If banks systemically suffer substantial losses following an abrupt rise in the physical risks or transition risks, climate change poses a considerable risk to the financial system.”

The researchers developed a metric for assessing climate risk, and found that for some banks with big fossil fuel exposures it was “economically substantial.”

Using Citigroup as an example, the researchers said the expected amount of capital that the bank would have needed to raise under the climate stress scenario to restore a prudential capital ratio increased by $73 billion in 2020, at a time when oil prices were falling as the pandemic reduced energy demand.

A Citigroup spokeswoman declined to comment on the paper.

Overall, bank risk measures for large banks in the United States, U.K, Japan, Canada and France tended to rise and fall over time but in tandem, they found.

The researchers did not consider the direct effects of climate-related weather events, though they said that incorporating such risks could be a next step.

U.S. banking regulators, including the Fed, are already moving toward requiring more disclosure of how climate-related risks could affect the value of banks’ assets.

(Reporting by Ann Saphir; Editing by Andrea Ricci)

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