Federal bank regulators are facing data gaps, speculation and inexactitude as they gear up for their unprecedented plans to review banks’ preparedness for climate change.
The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. are currently devising “scenario analysis” that would measure climate change risks in banks’ operations and loan portfolios.
The Fed’s planned “pilot micro-prudential scenario analysis exercise” for a handful of banks with more than $100 billion in assets will launch next year, the central bank’s new vice chair for supervision, Michael Barr, said in a Sept. 7 speech.
Regulators have for years relied on stress tests to determine big banks’ ability to survive severe financial downturns. And the parameters used in such tests are clearer, more empirical and rife with data compared with the more hypothetical information that’s available for climate change.
Scenario analyses are intended to test things like climate change’s effects on borrowers’ projects and bank properties’ direct exposure to such risks. Unlike stress tests, how climate change scenario analyses will work is far murkier. But they will require far more long-term, speculative thinking than what is done for stress testing, industry watchers say.
“With climate scenario analysis, it gets a lot more complicated,” said Todd Phillips, the director of financial regulation and corporate governance at the Center for American Progress. “The climate science is always developing and there’s just so much that is unknown about what will happen between now and the next 20 or 30 years.”
The Fed’s annual Comprehensive Capital Analysis and Review program tests banks on whether they have sufficient capital to survive and continue lending over nine quarters during financial crises of varying severity.
The exercise is uniform and the Fed reviews each bank’s submission. Banks that fare poorly can see their stock buyback and dividend programs curtailed to boost capital levels.
Climate scenario analysis wouldn’t work that way. Banks are comfortable measuring the effects of high unemployment or a falling stock market. But they aren’t as comfortable in measuring the years-long effects of global temperatures rising 2° Celsius on their loan books and physical properties.
The lack of data holds true for regulators, as well.
In May, the Bank of England said its new climate scenario analysis is “still in its infancy and there several notable data gaps.”
Those gaps are likely to get filled as regulators and banks get more experience with scenario analysis, the Bank of England report said.
“There’s still a lot that’s unknown,” Phillips said.
Details on how US regulators will conduct scenario analysis are scant.
Banks and regulators will have to be creative and get out of their stress-testing comfort zone, acting Comptroller of the Currency Michael Hsu said in a Sept. 7 speech.
“With climate-related risks, I believe we are much more exposed to failures of imagination—not asking enough ‘what if?’ questions—than we are to failures of stringency or consistency,” he said.
Unlike stress tests, scenario analyses will likely work best if regulators avoid detailed, one-size-fits-all instructions because each bank’s risks will be based on their individual business lines and geographical locations, experts say. Many large banks are already doing their own work on mitigating and measuring climate risks.
“The banks are all over the world. They have different types of exposures. So how could you really have standardized scenarios?” said Amber Hay, a partner at Arnold & Porter LLP and a former Fed attorney.
The Bank of England said different banks reported wildly different results about how they would deal with the same scenarios. Some banks used far more optimistic approaches than others.
“From a process perspective, supervisors will be very interested in knowing what it looks like when banks dream up their own scenarios,” said Randy Benjenk, a partner at Covington & Burling LLP.
Banks are concerned that climate scenario analysis may eventually result in increased capital requirements. Capital is, after all, a bank’s biggest protection against the risk that, say, agricultural loans go bad in drought or a hurricane knocks out oil refiners along the Gulf of Mexico.
But Hsu, Barr and other regulators so far have made clear that they don’t intend to take climate risk into capital planning.
Still, banks are concerned that the regulators’ stance will eventually change, and that climate will be taken into account when considering banks’ capital levels.
“There will just need to be a little more learning before regulators are comfortable hiking up capital requirements based on events that have not yet happened in our history,” Benjenk said.