U.S. Federal Reserve Announces Climate Scenario Analysis Program – Financial Services

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.

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