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ESG Focus: Fed Eyes Climate Stress Tests for Banks

ESG Focus | Oct 06 2021

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ESG Focus: Fed Eyes Transition Stress Tests For Banks

The US Federal Reserve is joining the push to stress-test banks for climate risks; a push that will force banks to potentially lay aside trillions in capital; apply further pressure to fossil-fuel producers; and help build macro and micro economic insight into the transition to build policy responses.

-Capital shortfalls for some banks will be substantial
-Bank risk to be coupled to country risk
-Focus is on transition risk over physical or liability risks
-APRA publishes latest info on bank climate vulnerability assessments

By Sarah Mills

The US Federal Reserve Bank of New York, which is the Federal Reserve's and US Treasury's money manager, has published a model for stress-testing big banks’ climate exposures.

If applied, the model will likely result in banks being required to lay aside greater capital to support their oil and gas assets, raising the cost of capital for holding fossil-fuel assets.

Morgan Stanley has estimated these capital shortfalls will, for some banks, be “economically substantial”.

Using one bank as an example, Banking Dive estimates the amount of capital Citi would have to set aside under the CRISK measure (systemic climate risk, which is the expected capital shortfall of a financial institution in a climate stress scenario ) soared to US$73bn last year.

Steps to implement climate stress tests for banks are already under way in other nations, well ahead of the Fed, as Europe pushes to lead the global transition and establish market dominance in a new energy order.

The Network of Central Banks and Supervisors for Greening the Financial System comprises 89 member countries.

The cost to banks of laying aside extra capital could be passed on to fossil-fuel companies, adding higher funding costs to the risk of stranded assets for shareholders in fossil fuels.

Alternatively, the banks could spread the capital imposts across the banks’ broader portfolios, or the banks could internalise the costs, hitting bank shareholder profits.

Whichever way, it would suggest rising costs for businesses and consumers until the transition is complete.

But banks stress tests are unlikely to happen any time soon, Morgan Stanley noting the paper's findings are likely to be implemented between 2023-2025.

The Fed research paper sets out a method for identifying assets vulnerable to climate shock and then calculating the likely resulting capital shortfall.

Bank risks to be coupled to country risk

Banking Dive reports that the paper also stressed the likelihood of reassigning or coupling bank-level CRISK to country level CRISK, increasing pressure on governments to regulate on climate, and providing deeper macroeconomic insight given transition risks extend across most sectors of the economy.

Sovereign laggards would likely suffer credit-rating downgrades and higher funding costs.

Not surprisingly, Federal Treasurer Josh Frydenberg recently warned Australia has much to lose if we are not transitioning swiftly, clearing the path for Prime Minister Scott Morrison for the COP26 in Glasgow.

"Australia has a lot at stake," says Frydenberg in a speech to the Australian Industry Group. "We cannot run the risk that markets falsely assume we are not transitioning in line with the rest of the world."

Paper examines transition risks only and notes risks are systemic

Climate change affects banks in two main ways: transition risks related to government climate regulation; and physical risks to bank assets such as flooding and drought. Liability risk is also a threat.

The paper addresses transition risks, not physical risks, but Reuters reports the latter may be addressed in future. Transition risks are easier to verify than physical risks.

The Fed applied the model to 27 of the biggest global banks, which supply 80% of loans to oil and gas companies. 

The paper’s authors found that while the effects on individual banks varied, they were highly correlated, pointing to systemic risk.

While this conclusion may appear self-evident, the paper represents the first step in a process.

The paper found climate risk also tends to move in tandem for large banks from the US, Canada, UK, France and Japan.

The research outlined a measure for transition risk, using stranded asset portfolio returns as a proxy for transition risk, as well as the likely effects of regulation such as carbon taxes.

The authors propose a measure called CRISK: the expected capital shortfall of a financial institution in a climate stress scenario; and notes this measure rose sharply in 2020.

This is not surprising given the jaw-breaking punch covid delivered to oil price volatility last year. Whether the CRISK measure reflects this non-climate-related skew is unclear.

Morgan Stanley reports CRISK is calculated as a function of the firm’s size, leverage and expected equity loss relating to climate stress.

The Fed news will come as no surprise to the banks, which have been reviewing their portfolios for climate exposures for years, given the writing has been on the wall.

APRA calls on five largest banks to conduct risk assessments

In early September, the Australian Prudential Regulation Authority published details of the climate vulnerability assessments (CVAs) that Australia’s five largest banks are conducting in response to APRA’s call in April (the Big 4 and Macquarie Bank).

Given Australia is a fossil-fuel based economy, one imagines the amount of money banks will be required to set aside under the Fed's scenarios will be substantial. 

The CVAs require banks report on the financial impact of climate on income statements, cash flow statements and balance sheets.

APRA advised that the CVAs could also be applied to the superannuation and insurance sectors and may be of use to other non-financial enterprises in Australia.

APRA adds liability risk to transition and physical risk in its assessments.

A link to the Fed paper is available here:

A link to the APRA paper is here:

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