The Federal Reserve has tasked six U.S. banks — Bank of America, JPMorgan Chase, Morgan Stanley, Citigroup, Goldman Sachs and Wells Fargo — to perform climate risk analysis on themselves.
There are two problems that these banks need to solve. First, they need to assess the impact of climate disasters — such as hurricanes, floods, heat waves and droughts — on their loan portfolios and real estate holdings.
The hypothetical scenario provided by the Fed focuses on events happening in the Northeastern U.S. These banks are not obligated to calculate the hypothetical losses from those disastrous events.
Meanwhile, the second part of the analysis involves assessing the ten-year impacts on banks' corporate and commercial real estate holdings under a transition. There are two hypothetical scenarios involved in the second module — a situation where fossil fuel use continues and a different situation if the economy has shifted to zero-emissions output by 2050.
The pilot has some similarities with the mandated bank stress test, which examines a bank's readiness in financial crises. However, Fed vice head for supervision Michael S. Barr said the new task had a narrower focus. It includes an assessment of the bank's ability to manage material risks in the event of climate disaster.
"The exercise we are launching today will advance the ability of supervisors and banks to analyze and manage emerging climate-related financial risks," Barr added.
Per Fed's instruction, these banks have until July 31 to submit the final reports. The Fed will publish the summary of those reports at the end of this year. However, the central bank will not go into detail about the solutions provided by the banks.
Analysts said it was likely that the Fed had prepared this new test in the past three years. In 2020, a financial stability report discussed the probability of the said test. One year earlier, Fed vice chairman Lael Brainard brought up the issue of climate change and financial security.
Despite the new measure, Fed chairman Jerome Powell recently said his agency would not turn into a "climate policymaker." He maintained that the Fed would not use its authority to interfere with industries that did not align with the green economies, such as the fossil fuel industry.
Regardless of the Fed's stance, officials said it was the agency's responsibility to acknowledge the risks of climate change as they affect the stability of the financial sector. In December 2022, the Fed published guidelines for large banks to mitigate climate risks.
In the past, some Congress members — mostly Republicans — urged the Fed not to dabble in climate policy. Some entities have also contested the Fed's initiatives concerning climate issues.
Meanwhile, other central banks have taken a clearer stance on understanding the risks of climate change on finance. The Bank of England, for example, recently published its assessment of insurers' and banks' risk exposure to the threats of climate change.
Responses to Fed's new initiative
Fitch Ratings senior director Mark Narron welcomed the Fed's pilot analysis, saying it could improve the understanding of banks' management, vulnerabilities and risk controls.
While Better Markets president and CEO Dennis Kelleher said the new initiative showed the Fed taking action, he called it a "weak start." Kelleher explained that the assessment did not fully cover areas with the biggest risks, namely investment banking portfolios and commercial loans.
Wharton School of the University of Pennsylvania professor Christina Parajon Skinner said the pilot threaded between improving the security of the financial system and staying within the central bank's legal mandate.
"The Fed has really, I wouldn't say stepped back, but I think it's become more discerning and more judicious in terms of what's on the table for its approach to climate change," Skinner added.
The banks that received the mandate have yet to comment on their new tasks.