Blog: US Federal Reserve Launches Climate Scenario Analysis Exercise … – Mondaq

United States:

US Federal Reserve Launches Climate Scenario Analysis Exercise

25 January 2023

Mayer Brown

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On January 17, 2023, the Board of Governors of the Federal
Reserve System (“Federal Reserve”) launched its pilot
climate scenario analysis exercise (“CSA”) by publishing
instructions for the six US banking organizations that will
participate.1 The Federal Reserve first announced the
CSA on September 29, 2022, as we discussed in a
previous Legal Update
.

As part of the CSA, participating organizations will submit data
templates, supporting documentation, and responses to qualitative
questions to the Federal Reserve by July 31, 2023. The Federal
Reserve is continuing to collect information on climate risk
management practices, and banks should consider reviewing the CSA
instructions to better understand the Federal Reserve’s
expectations.

In this Legal Update, we provide background on the Federal
Reserve’s climate risk management initiative and highlight key
items in the CSA instructions.

Background

The CSA is intended to help the Federal Reserve gather
information about the climate risk management practices of large
banking organizations as well as enhance the ability of the
organizations to identify, measure, monitor, and manage
climate-related financial risks. In some respects, the pilot CSA is
similar to a limited information collection exercise that the
Office of the Comptroller of the Currency (“OCC”)
undertook in 2021 with some of the large financial institutions
that it regulates.2 However, the pilot CSA appears to
request significantly more data and analysis from banking
organizations than the OCC did in its exercise.

The Federal Reserve notes the CSA is separate and distinct from
regulatory stress testing, which is intended to determine whether
large banking organizations have sufficient capital to continue
lending through an economic recession. Importantly, the CSA should
not have consequences for bank capital or supervisory
implications.

CSA Instructions

The CSA requires participating organizations to analyze the
impacts of given climate scenarios as they relate to specific
assets in their portfolios. The exercise consists of two modules:
(i) a physical risk module that represents the harm to people and
property that may result from climate-related events such as
hurricanes and wildfires and (ii) a transition risk module that
represents stresses that may result from the transition to a lower
carbon economy. For the physical risk module, the Federal Reserve
leveraged the Intergovernmental Panel on Climate Change’s
(“IPCC”) existing work on greenhouse gas emissions
concentration trajectories to design its own scenarios. For the
transitional risk module, the Federal Reserve used scenarios
provided by the Network for Greening the Financial System
(“NGFS”).3

The scope for each module is limited to a subset of each
organization’s loan portfolio. For physical risks, each banking
organization must estimate the effect of the scenarios on
residential real estate and commercial real estate loan portfolios
over a one-year horizon in 2023. For transitional risks, each
organization must estimate the effect of the scenarios on corporate
loans as well as residential real estate and commercial real estate
loan portfolios over a 10-year horizon from 2023 to 2032. The CSA
notes that it will not address any of an organization’s trading
book exposures.

The Federal Reserve expects banking organizations to calculate
their best estimates of scenario-adjusted Probability of Default
and Loss Given Default as of January 1, 2023. Data to be submitted
to the Federal Reserve must be prepared in good faith using
reasonable efforts to conform with the CSA instructions. Unlike the
stress testing conducted through the FR Y-14 information collection
process, the Federal Reserve will not require an organization’s
chief financial officer to attest to the information submitted for
the CSA.

Additionally, the CSA exercise requires participants to submit
responses to qualitative questions focused on four primary areas:
(1) governance and risk management, (2) measurement methodologies,
(3) results, and (4) lessons learned and future plans. The
governance and risk management section will discuss the
organization’s current practices with respect to managing
climate-related financial risks, such as how the organization uses
climate scenario analysis to inform its business decisions. The
measurement methodologies section seeks information about
approaches that the organization used in estimating results for
each scenario within the two modules. The results section requires
the participating organization to provide a narrative description
of the results under each scenario. Finally, the lessons learned
and future plans section covers issues including how the banking
organization expects to use climate scenario analysis to inform its
future business decisions and what other approaches or
considerations the organization may employ in any future similar
exercise.

Conclusion

The CSA will only affect six of the largest banking
organizations in the United States and, even then, should not have
regulatory or supervisory consequences. However, much as capital
stress testing was once limited to a small number of banks, we
expect that supervisory expectations for climate scenario analysis
will continue to expand. Therefore, other banking organizations may
consider reviewing the CSA instructions to understand how the
Federal Reserve is thinking about scenario design and analysis.

The CSA instructions indicate that the submissions will focus on
changes to risk metrics rather than estimates of losses. This
limited ambition may reflect the difficulty in quantifying the
long-term consequences of climate change over the relatively short
horizons used in scenario analysis. Additionally, it may help to
head off concerns that regulators are implicitly discouraging
banking organizations from making certain loans based on the size
of the losses estimated through scenario analysis. Given the
politically charged nature of environmental, social and governance
(“ESG”) issues, including Chairman Powell’s recent
declaration that the Federal Reserve “will not be a climate
policymaker,” it is not surprising that the CSA is carefully
drafted to address limited aspects of climate-related financial
risk management.4

Footnotes

1. Press Release, Federal Reserve Board provides
additional details on how its pilot climate scenario analysis
exercise will be conducted and the information on risk management
practices that will be gathered over the course of the exercise
(Jan. 17, 2023), https://www.federalreserve.gov/publications/climate-scenario-analysis-exercise-instructions.htm.

2. See our Legal Update on the OCC exercise: https://www.mayerbrown.com/en/perspectives-events/publications/2022/01/us-occ-extends-climate-risk-survey.

3 See our Legal Update on NGFS scenario: https://www.mayerbrown.com/en/perspectives-events/publications/2021/06/network-for-greening-the-financial-system-issues-second-iteration-of-climate-scenarios.

4. Victoria Guida, Powell vows that Fed “will not be
a climate policymaker,” Politico (Jan. 10, 2023).

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This
Mayer Brown
article provides information and comments on legal
issues and developments of interest. The foregoing is not a
comprehensive treatment of the subject matter covered and is not
intended to provide legal advice. Readers should seek specific
legal advice before taking any action with respect to the matters
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