The Federal Reserve Board issued a report last week that details the Climate Scenario Analysis (CSA) exercise that it conducted with six of the nation’s largest banks.
The report describes how these banks are using climate scenario analysis to explore the resiliency of their business models to climate-related financial risks. The banks that took part in the exercise were Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo.
The report revealed some key insights as a result of the exercise. Among them, it said that the participants used climate scenario analysis to consider the resiliency of their business models to a range of climate scenarios and to explore potential vulnerabilities across different time horizons.
It also revealed that they took different approaches to construct the detailed physical and transition risk scenarios used in the pilot CSA exercise and to translate those scenarios into estimates of climate-adjusted credit risk parameters. The differences in approach were driven largely by participants’ business models, views on risk, access to data, and prior participation in climate scenario analysis exercises in foreign jurisdictions.
Further, it said that most participants relied on existing credit risk models to estimate the impact of physical and transition risks on their portfolios. They assumed that historical relationships between model inputs and outputs continue to hold as the climate and the structure of the economy evolve. In addition, participants reported significant data and modeling challenges in estimating climate-related financial risks. For example, they cited a lack of comprehensive and consistent data related to building characteristics, insurance coverage, and counterparties’ plans to manage climate-related risks. Also, in many cases, they relied on external vendors to fill data and modeling gaps.
Among other findings, participants reported that better understanding and monitoring of indirect impacts and chronic risks are important for managing climate-related financial risks. They also highlighted the important role that insurance plays in mitigating the risks of climate change for consumers, businesses, and banks. Additionally, they noted the need to monitor changes across the insurance industry, including changes in insurance costs over time, and the impacts of those changes on consumers and businesses in specific markets and segments.
The report also revealed that the banks identified key design choices that meaningfully impacted the insights drawn from the exercise. These included choices related to the scope of the shocks, scenario severity, the starting point of the exercise, insurance assumptions, and balance sheet assumptions.
Overall, the banks suggested that climate-related risks are highly uncertain and challenging to measure. The uncertainty around the timing and magnitude of climate-related risks made it difficult for them to determine how best to incorporate these risks into their risk management frameworks.
In summary, the exercise highlighted data gaps and modeling challenges that arise when estimating the financial impacts of highly complex and uncertain risks over various time horizons.
The Fed pointed out that the exercise was exploratory in nature and does not have capital consequences. Drawing on lessons learned from the exercise, the board will continue to engage with participating banks regarding their capacity to measure and manage climate-related financial risks.