Legislation recently introduced in Congress would direct the Federal Reserve to conduct stress tests on large financial institutions to measure their resilience to climate-related financial risks.
The Climate Change Financial Risk Act of 2021 – introduced by U.S. Sens. Patty Murray (D-WA) and Brian Schatz (D-HI) along with Rep. Sean Casten (D-IL) — would require the Fed to establish an advisory group of climate scientists and climate economists to help develop climate change scenarios for the financial stress tests.
“The climate crisis is already here—we see it in rising sea levels and more and more extreme weather events every year—and the significant financial costs that come with them,” Murray said. “We need to have contingencies ready to mitigate the financial damage of climate change to families in Washington state and our country’s economy as a whole. By ensuring the U.S. financial system is better prepared to confront climate change, we’re protecting the pockets of Washington state families. I’m glad that President Biden and his administration are taking the climate crisis seriously, and this bill will ensure that the Federal Reserve follows suit.”
With the input from the advisory group, the Fed will create three stress test scenarios: a 1.5-degree Celsius warming scenario; a two-degree scenario; and a “business as usual” scenario. For each scenario, the Fed will quantify how climate-related physical and transition risks could disrupt the economy and global business operations. The stress tests would be conducted every two years on the same large financial institutions currently subject to Comprehensive Capital Analysis and Review (CCAR) stress tests. This includes firms with more than $250 billion in total consolidated assets,
Each covered institution would be required to create a remediation plan describing how it would evolve its capital planning, balance sheet, and other business operations to respond to the most recent test results. Fed objections to a remediation plan would limit the institution’s ability to proceed with capital distributions until the plan is adequately improved. Institutions would not have to increase their current capital based on the results of a climate stress test.
Further, the Fed would partner with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation to design an exploratory survey to assess the ability of sub-systemic banks — those with more than $10 billion in assets — to withstand climate risks. The survey would be administered every two years.
Financial institutions face the risk of direct losses from severe weather events and fundamental changes like drought and sea-level rise, such as lower property values from increased flooding. They also face risks from market instability, an erosion of investor confidence, and changes in carbon-intensive asset values resulting from government policies and consumer preferences, the lawmakers said.