The U.S. Federal Reserve Board’s plans to engage in climate-related scenario analysis with some of Wall Street’s largest banks will uncover potential shortcomings — as well as good practices — in the banks’ efforts to grapple with climate change, says Moody’s Investors Service.
In a new report, the rating agency said the Fed’s planned scenario analysis exercise with six big banks — Bank of America Corp., Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley and Wells Fargo & Co. — is a positive for the banks as it is expected to produce useful insights for them as they incorporate climate-related risks into their operations.
The Fed released details of the planned exercise, which will explore the possible impact of both physical and transition risks on the banks’ loan portfolios under varying climate scenarios, last week.
“Importantly, participants are instructed to include scenarios of varying severity and including and excluding insurance as a mitigant. They must also exclude any government aid as a mitigant, which historically has been an important factor protecting U.S. banks from credit losses following climate disasters,” Moody’s said in its report.
The banks are expected to submit their responses to the Fed by July 31, with the regulator’s results to be released by the end of the year.
“We expect the published aggregated findings to identify good practices for climate risk assessments, as well as potential deficiencies in the banks’ data sets and methodologies,” Moody’s noted.
Moreover, given that it’s a pilot project, the review will not generate capital or supervisory consequences for the banks, it said.
“An interesting distinction from the climate stress tests that the European Central Bank conducted in 2022 is that the Fed is focused on the change in probability of default, loss given default and, where applicable, internal risk ratings, rather than aggregated loss estimates, as are typically the outcome of stress-testing exercises,” the report said.
Additionally, the Fed’s exercise will seek qualitative information on the banks’ governance, risk-management practices, measurement methodologies, results, and lessons learned and future plans, it noted.
Along with the big banks that are participating in the exercise, smaller banks may also benefit “from the development of climate related financial risk management standards, best practices, data and tools,” Moody’s said.
“If not, they risk negative credit implications from physical climate risks and carbon transition risks that could be substantial if not managed and mitigated. As smaller banks tend to have more concentrated geographic footprints and loan portfolios than larger banks, climate risks may prove even more significant to less systemic banks’ credit outlook,” it said.