NY Fed Research Finds Link between Climate Change and the Financial System, Fed Chair Talks Climate Scenarios
October 4, 2021
The Federal Reserve Bank of New York (NY Fed) recently published research on the effect of climate change on the financial sector, “either via disruptions in economic activity resulting from the physical impacts of climate change or changes in policies as the economy transitions to a less carbon-intensive environment.”
The authors developed a stress testing procedure called CRISK, which is the expected capital shortfall of a financial institution in a climate stress scenario. They applied CRISK to 27 largest global banks, whose aggregate oil and gas loan market share exceeds 80%, and found that climate risk for some of these banks were “economically substantial.” For example, the expected amount of capital that one of the largest U.S. banks would need to raise under the climate stress scenario to restore a prudential capital ratio increased by $73 billion in 2020.
On September 30, Federal Reserve Chair Jay Powell emphasized the importance of climate scenario analysis when testifying in front of the House Financial Services Committee. In response to a question regarding the assessment of climate-related financial risks, Powell stated that “scenario analysis is almost certainly going to be one of the principal tools for doing exactly that and it’s very different from the stress test.” However, as he has done in the past, Powell underscored the difference between scenario analysis and stress tests. He explained that scenario analysis will help institutions understand climate-related risks. Stress tests, on the other hand, have “consequences” such as limitations on distributions, etc.
Earlier in the week, on September 27, at a National Association for Business Economics conference, Federal Reserve Governor Lael Brainard said that climate risk required more regulatory attention. According to Politico, Brainard said that the Fed had fallen behind other countries in preparing the financial sector to deal with climate risk, adding that large U.S. banks are already being supervised abroad “to make sure they are measuring, monitoring and managing climate-related financial risks.”