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.
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.
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.
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
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.