With climate and environmental risks coming to the fore, regulatory authorities globally are ramping up efforts to assess the financial sector's vulnerability to these risks. The Fed has just launched a CSA pilot on the six largest U.S. banking groups, and will make the aggregated results available toward year-end. The Fed's main goal is to gather qualitative and quantitative information about the climate-risk-management practices of the largest U.S. banking groups and ultimately enhance banks and supervisors' ability to identify, measure, monitor, and manage climate-related financial risks. This supports our view that climate stress tests and scenario analyses are becoming common tools for financial authorities to assess potential systemic risks (see "Bank Regulation And Disclosure To Foster Climate-Related Risk Analysis," published on Oct. 3, 2022, on RatingsDirect).

The Fed's CSA takes the same direction as the ECB's 2022 climate-related-risk exercises, with some differences: 

Disclosure.  Similar to how the ECB presented its climate stress test (CST) and thematic review findings, the Fed will disclose its results in an aggregated fashion, with no bank-specific information. However, contrary to the ECB, the Fed's CSA will not disclose any estimate of potential losses resulting from the climate scenarios it has used. We understand the Fed will only release qualitative information about banks' climate-related risk, whereas the ECB disclosed the aggregated credit and market losses related to its climate transition and physical risk scenarios, which were based on banks' own projections.

Scope.  Participants in the Fed's CSA are the six largest U.S. banking groups, namely Bank of America Corp., Citigroup Inc., The Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley, and Wells Fargo & Co., together representing more than 50% of U.S banking system assets. The ECB cast a wider net. The qualitative part (modules 1 and 2) of the CST involved 104 European significant institutions while the thematic review covered 186 European banks (including 79 less significant institutions), representing more than two-thirds of the European banking sector's assets.

Scenarios.  Like the ECB's CST, the Fed's CSA covers both transition risk and climate physical risk, in two distinct and independent modules:

• To assess transition risk, the Fed uses two climate scenarios released by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). The first is the Current Policies scenario (which assumes no new climate policies are implemented) and the second is the Net Zero 2050 scenario (in which global warming is limited to around 1.5°C through new stringent climate policies). These are the same as the ECB's orderly transition and hot-house scenarios. The ECB also extended its analysis to a third NGFS scenario--disorderly transition--which assumes new climate policies are not introduced until 2030, before more stringent policy actions are taken to limit global warming to below 2°C.
• To assess climate physical risk, the six U.S. banks will be tested under a common hazard--that is, a severe hurricane (or a series of events) in the Northeast--and an idiosyncratic hazard that each participant will choose based on how material its business model's exposure is to that hazard. Assumptions will be modeled on the Intergovernmental Panel on Climate Change (IPCC)'s Shared Socioeconomic Pathways (SSPs) or Representative Concentration Pathways (RCPs). In addition to direct impacts, participants are encouraged to incorporate indirect consequences of the event where possible (for instance effects on the economy). The ECB's CST physical risk analysis covered droughts, heat waves, and floods, modeled on the scenarios and assumptions developed by the NGFS and the European Commission's Research Centre.

Horizons.  The physical risk analysis timeframe is one year for both the Fed and ECB. For transition risk, the ECB used a short-term tail risk analysis (three years), as well as a long-term transition path (30 years); whereas the Fed will include only a 10-year horizon up to 2032. Given the long-term nature of these risks, we consider the longer horizon of the ECB's CST to be more conservative when assessing banks' vulnerability to transition risk.

Portfolios in scope.  In terms of banks' exposures, we view the ECB's CST as offering wider coverage because it examined banks' retail mortgages and corporate loans, including those to SMEs and commercial real estate (CRE), for both physical and transition risks. Conversely, the Fed will focus on residential real estate and CRE loan portfolios for the physical risk module, and corporate and CRE loan portfolios for the transition risk module. While the Fed's CSA will not include a review of banks' trading books, the ECB's CST analysed how corporate bonds and equities within banks' trading books would be affected by a sharp price decline in the short-term transition scenario.

Geographic scope.  For its physical risk module, the Fed's CSA has a narrower geographic scope than the ECB's CST as the analysis only covers the Northeast (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, West Virginia, District of Columbia). The Fed chose this region because this is where all participants have material commercial and residential real estate exposures and because it could see an increase in the severity of these climate hazards.

Balance sheet approach.  Both the ECB and the Fed's exercises are based on static balance sheets (except for the ECB's long-term transition scenario). While we acknowledge that a dynamic balance sheet approach would have the benefit of testing the strategic actions management might take to mitigate the effects of climate change (and therefore be more realistic), we consider the static balance sheet approach more conservative and consistent with the approach used in traditional regulatory stress testing.

Projected risk parameters.  Participants must assess the impact of the scenarios on specific risk parameters on selected obligors or facilities for each year in the projection horizon: probability of default, internal risk rating grade, and loss given default.

Mitigants. 

We observe that the Fed's pilot exercise considers insurance as a mitigant of banks' potential losses under some of the scenarios. Conversely, in the ECB's CST, the credit loss projections on climate physical risk provided by the banks did not, for most banks, factor in insurance coverage. Notably, in the ECB's CST private insurance coverage was considered by less than 25% of banks' loss projections, while for half the banks this insurance covered a large portion (over 50%) of collateral losses. We acknowledge that insurance helps banks manage their credit risks, and somewhat mitigates exposure to physical risk. This may help contain banks' losses when events occur. However, exposure to increasingly extreme weather events can adversely affect the cost of insurance and property valuations, and can lead to insurance coverage becoming unaffordable or not available at all. We have observed significant insurance rate hikes in areas that habitually experience weather-related losses, and some insurers have withdrawn from certain markets--for example, Florida and California (hurricanes and wildfires, respectively)--where writing new business or renewing policies is unattractive. In our view, the future availability and affordability of insurance coverage should not be taken for granted and could create additional risks for banks (see: "Physical Risk | If extreme weather events become the norm, how might individuals, companies, and governments manage the costs?" in Global Credit Outlook 2023, available on www.spglobal.com).

Overall, we view positively the Fed's launch of its pilot exercise on climate risks.  It represents another step forward in the analysis of the financial sector's vulnerability to climate risks. We view it, and other initiatives globally, as a sign that regulators are starting to more proactively respond to the climate-related financial risks banks face. The exercise should also heighten U.S. banks' awareness of their current ability to measure climate-risk exposures and foster efforts to further develop forward-looking data and methodologies to monitor and manage them.

Given the exploratory nature of the exercise, the Fed has announced that no additional capital requirements will be imposed on the back of this exercise. Nevertheless, we assume that the regulator will use the results to inform its supervision, particularly where it identifies material risks or deficiencies in risk management and data.

We do not expect the Fed's exercise to affect our ratings on banks, particularly given that only aggregated results will be published. However, more granular information on banks' exposures and vulnerabilities to climate risks should ultimately inform our credit analysis.