Regulators want to stress-test banks for climate risks. Can it work?

Below is a lightly edited transcript of the podcast:

WELLS FARGO PROTEST: No more subsidies for fossil fuel companies! No more debate! Wells Fargo won’t forget! You ain’t seen nothing yet! Wells Fargo won’t forget! You ain’t seen nothing yet!

CHASE BANK PROTEST:We’re here to continue to apply pressure to Chase Bank because they are the number one investor in fossil fuel infrastructure in the world.

RASHIDA TLAIB: Do you believe that climate change is a serious risk to the financial system, not only the planet?

JAMES GORMAN: If we don’t have a planet, we’re not going to have a very good financial system.

TLAIB: That’s right.

LANG: The climate crisis is reaching a boiling point, and big banks are certainly feeling the heat as activists and lawmakers alike are questioning their role in providing capital and services to companies whose emissions are driving global warming.

The Federal Reserve in November for the first time recognized climate change as a potential risk to financial stability, warning that banks could be exposed to losses from natural disasters that aren’t accounted for in current financial models.

A month later, the central bank officially announced that it had joined the Network for Greening the Financial System, an international group of central banks and bank supervisors focused on examining the effects of climate change on the banking system.

The Fed could soon follow in the footsteps of other international regulators and begin taking a closer and more methodical examination of how the effects of climate change — such as flooding coastal cities, land loss, more frequent and intense weather events, and more — could impact the bottom lines of the banks it supervises. Stress testing for climate change, in other words.

The Fed has been stress testing banks for severe economic conditions for more than a decade, running banks’ portfolios through models that determine how they would perform in various hypothetical recessions and requiring capital adjustments based on the results. In theory, that process protects a bank from potential losses when a real economic shock materializes.

So why not test bank portfolios against a rise in sea levels or increased wildfires? And what about financial losses from a declining use of oil and gas as the U.S. attempts to slash emissions? It’s an idea that has surprisingly broad support both in climate and financial circles as an effective way to compel banks to think about their long-term risk exposure. But it also has fierce opponents, who fear that climate stress testing takes the Fed beyond its legal scope.

For American Banker, I’m Hannah Lang, and this is Bankshot, a podcast about banks, finance and the world we live in.

Before we talk about climate stress testing, we should take a moment to talk about plain old stress testing. As supervisory tools go, it’s relatively new, having been implemented for the first time in the wake of the 2008 financial crisis. But since then, it’s become kind of a big deal.

JEREMY NEWELL: Since the financial crisis, a real cornerstone of the regulatory framework has been an annual exercise for larger banks to stress test their balance sheets, and to assess whether they have the financial wherewithal to survive a severe economic downturn.

LANG: This is Jeremy Newell, a partner at Covington & Burling. He also used to be the regulatory policy adviser in the Banking Supervision & Regulation Division at the Fed.

NEWELL: In the traditional stress tests, we have tons of historical data on how banks’ loans and investments perform during times of stress, and we also have lots of prior economic downturns that we can look to for precedents. And so in traditional stress testing, we have lots of real data to build realistic scenarios, and lots of real data to assess what might happen to banks, if those scenarios were actually to happen.

LANG: This year, for example, the Fed is testing banks against a baseline and a severely adverse scenario to see how their balance sheets hold up. Both scenarios have 28 different variables, including changes in the unemployment rate, interest rates, stock market prices and gross domestic product. Based on how banks do in the test and how much money they plan to distribute to their shareholders, the Fed applies a capital ratio that banks have to hold against their assets.

Most developed countries perform some kind of stress testing, and they go about it in very different ways. But some regulators are already blending climate change risks with more traditional economic risks in their supervisory stress tests.

The Bank of England this year will become the first central bank to stress test its country’s banks against the effects of climate change, while the European Central Bank has a climate stress test planned for Eurozone banks in 2022. The Bank of England plans to test U.K. banks on three different climate scenarios over 30 years that incorporate both physical and transition risks.

This is European Central Bank President Christine Lagarde speaking in March.

CHRISTINE LAGARDE: The economy-wide climate stress test that we are currently carrying out shows that the risks to the Euro-area economy could be substantial. The exercise also sheds light on the long-run tradeoff between the transition to a green economy and climate inaction.

LAUREN ANDERSON: Obviously, this work has been going on in the EU and the UK for several years now, and over time, more members of the international regulatory community have joined those international efforts to talk about climate related risk.

LANG: This is Lauren Anderson.

ANDERSON: I’m Lauren Anderson, senior vice president and associate general counsel at the Bank Policy Institute. During the last administration, the US was — the US regulators were not necessarily given free rein to participate in a lot of that discussion. That being said, I think they were very closely following what was going on. And then as we started to move towards a shift in administration, obviously climate really came back on the agenda.

LANG: Fed Chair Jerome Powell has said the Fed is looking at what other central banks are doing on climate risk, which includes stress testing, but that it has not made a decision on its own approach just yet. This is Powell explaining his position to the House Financial Services Committee in March.

JEROME POWELL: So we’re looking at it carefully. We actually just are in the very early stages of considering stress scenarios and that’s what others are doing too. It’s an emerging idea. It’s not actually something that people are conducting now, but we’re doing that and many other things, again, to get a basic understanding of how the financial system can be resilient against what may be very significant emerging risks over time.

SARAH DOUGHERTY: I will say that they they’re doing their research. They’re gathering the data and the information. Do I think that the likely end includes some sort of stress test? Yes. But I know them. They’ve got to go through their process. They’ve got to get to the right place. But what information I know and what the research indicates that is likely where they will end.

DOUGHERTY: I am Sarah Dougherty, senior green finance manager at the Natural Resources Defense Council.

LANG: Sarah also spent seven years at the Federal Reserve Bank of Atlanta before joining NRDC.

DOUGHERTY: Having worked there, it’s a great institution. [In] part, it needs to go to a certain speed of doing things through analysis, research, etc., because that’s the way they operate — they need to operate. They have huge amount of trust in what they do by being the one that decides the amount of money that’s in circulation in our economy. That’s a huge burden, so you shouldn’t be making things willy-nilly.

LANG: In fact, the Fed has spent the last few months explaining why it feels it needs to take a closer look at climate change and what effect it could have on the banking system. Here’s Powell again, this time in December.

POWELL: Climate change is nonetheless relevant to our existing mandates under the law and let me tell you why. One of our jobs is to regulate and supervise banks and to look out for the stability of the financial system. The public will expect that we will do that so, will expect that those important institutions will be resilient against the many risks that they face.

DOUGHERTY: As soon as you start reading what their mandates are, it’s impossible not to think how is that not the Fed’s role.

NEWELL: The beautiful thing in that regard is that risk is an apolitical issue. And so, consistent with the approach they take in lots of other places, I think they’ll be staying laser-focused on understanding and addressing the risks at hand, [and] is probably, again, a safe space for them to operate from an independent standpoint.

LANG: Still, some feel that the Fed’s effort is insincere.

LANG: So do you ultimately think climate change poses a risk to the financial and the banking system here in the in the US?


LANG: This is John Cochrane, a senior fellow at the Hoover Institute.

COCHRANE: So let’s look historically, we’ve seen many transitions before, as you mentioned. Horse buggies to cars, railroads to airplanes; coal has been basically phased out in the U.S. Many economic — to typewriters to computers — losing money on the old companies has never caused financial problems. So why would the slow predictable decline of coal and fossil fuels cause not just somebody to lose money on those stocks, but bring down the banking system through a massive wave of unexpected losses? Sorry, that’s a dream scenario.

LANG: Capitol Hill Republicans have also expressed concern that actions on climate from the banking regulators could politicize the banking system. Here’s Congressman Andy Barr of Kentucky in March.

ANDY BARR: I certainly understand that changes to weather and weather patterns could pose risk to individual credits or insurance policyholders, but linking hypothetical climate scenarios to risk to the entire financial system seems to me highly speculative.

COCHRANE: There are many other risks. I sit up at night worrying about when North Korea makes the ATMs go dark. There’s a big risk. Another pandemic could come, you know, a nuclear weapon could go off somewhere. Something, anything that sends people running for the ATM machines is a financial risk. And if they’re consumed with climate inequality and racial issues, they’re not paying attention to the issues that it’s their job to pay attention to, and the next one will come by surprise again.

LANG: Still, many banks in the U.S. are already starting to take action on climate on their own, without being required to by regulators. Wells Fargo, Goldman Sachs, Citigroup, Morgan Stanley, Bank of America and JPMorgan Chase have all unveiled new climate goals in the last six months, each pledging to not provide funding to any Arctic energy projects and committing in some way to cut emissions.

LANG: If you could just introduce yourself with your name and title, that would be great.

MAYRA RODRIGUEZ VALLADARES: Sure. Mayra Rodriguez Valladares, managing partner of MRV Associates, which is a financial risk consultancy and training company in the New York area. The good thing is that, unlike other aspects — such as many of the rules that came out of Dodd Frank, where there was a lot of contention between the banks and the regulators — fortunately here, what I’m seeing, both with my banking clients and in general, is that the banks, all the executives and senior personnel, they’re aware that climate change is real. And they’re much more … how shall I put it … amiable in working with the regulators. So that’s important, right? Because if there’s a lot of resistance from the banks, then we would have a big problem.

ANDERSON: There’s been huge demand on the client side for more sustainable financing options — greater corporate social responsibility, awareness, more disclosure around risks. I mean, you see huge demand in the millennial space for this sort of information. I think banks are also, they’re really feeling it from their employees as well. So, you know, when they do their internal employee surveys environment and climate is a big issue for employees.

LANG: What is undeniable is that the Fed is moving forward in a much more public facing way on climate change. As I mentioned before, it has joined the Network for Greening the Financial System, and just this year it has created a Supervision Climate Committee and a Financial Stability Climate Committee. Fed Gov. Lael Brainard in March also suggested that it might be helpful if banks were to undergo a kind of scenario analysis — something like a low-wattage stress test — to assess the physical and transition risks of climate change.

VALLADARES: You have the physical risks of climate change, meaning more frequent and very damaging fires, more frequent and excessive, frankly, hurricanes, flooding, and so that physical damage to property, most unfortunately to people, then of course, translates into higher probabilities of default to a bank or other kinds of financial institutions, because those individuals or companies suffering that physical damage may be late or not pay at all.

NEWELL: The other category of risk that both banks and regulators focus on are so called transition risks. And so transition risks are financial risks associated with the long-term adjustment of the economy to a carbon neutral economy, and so think changing business models, the way that the transition over time to a carbon-free economy may impact different business models, different assets, different market prices.

LANG: So can climate risks be quantified in a reliable way? We’ll find out after this short break.

LANG: Climate risks are hard to see coming. We have no idea how many severe weather events we might experience in the next five years, where they might hit or how they might drive losses for banks, if at all. And we have no insight into how a shift to a carbon neutral economy might occur and what it would even take to phase out fossil fuels. But the same can be said for economic downturns, but the Fed already requires banks to be prepared for that eventuality with stress testing.

LANG: Do you think that stress testing banks for climate exposure is a good idea? And what in your mind, would that regime look like?

DOUGHERTY: Yes, 100% emphatically yes. This is how we’re going to know what’s in the individual institutions as well as the risk to the entire financial system. If we don’t do it, it’s like we see ’07 happening, and we did nothing knowing what was coming in ’08. That’s where I feel we are. We are negligent if we don’t try and prepare ourselves; then we’ll just be repeating it.

NEWELL: I think policymakers have gravitated towards this idea of stress testing, around climate change because stress testing is a process that bank regulators have a lot of experience with conceptually.

LANG: But conceptual frameworks only get you part of the way there. The economy has experienced countless recessions of varying severity, and economists have some sense of how bad things can get and what preventative measures can stop those things from happening. But climate change bring with it far more uncertainty.

NEWELL: Stress testing for climate related risks is inherently different. The whole point is that the transition to a carbon neutral economy is unprecedented and entirely unlike anything that’s happened before, and so that means, in contrast to the prior stress testing initiatives that the regulators have done, climate related stress testing is much more of a ‘what if’ exercise.

COVAS: The fact that you have more extreme weather events, and, and other events that could create large losses for the financial sector, for that to materialize, you need to just assume very long horizons.

COVAS: I’m Francisco Covas, head of research at the Bank Policy Institute. This level of granularity creates significant challenges for both central banks and banks, how to model that. And the risk is that if you don’t really understand how the economy is going to behave, or all these assumptions you’re making, ultimately, you could just be looking at the wrong scenarios, and making the wrong assumptions, and just takes time to figure that out.

VALLADARES: Even figuring out what data will banks need to measure their exposure to physical and transition risk of climate change is no easy task. And then how are you going to obtain that data? How are you going to cleanse it? How are you going to aggregate it? How are you going to use it to quantify exactly how you’re exposed to climate change is not easy, even for the largest, most globally systemically important banks.

LANG: Sarah Dougherty, on the other hand, points out that there are already models of how climate change might affect things like sea levels and natural disasters, and that scenarios to test banks against could revolve around goals the U.S. has already set on emissions.

DOUGHERTY: We meet the Paris Agreement targets and we keep it below 2%. That’s one scenario. So then you can kind of model what’s going on with, you know, storms, etc., because you know this. So you have those different scenarios, and we just take climate modeling and data and what does that do to our physical assets, as well as thinking through the transition risks that’s going to be different under each.

LANG: There is also the underlying question of what climate stress tests might be used for. Treasury Secretary Janet Yellen, for one, has indicated that she wouldn’t expect any climate stress tests to be used to impose additional capital requirements on banks.

JANET YELLEN: I think the purpose is — maybe we should call it scenario analysis rather than stress tests — is for financial institutions and for the regulators to better understand the risks that climate change owes to the health and resilience of core financial institutions, and it will help those institutions better manage and understand the risks.

LANG: But it’s also unclear if the results of any such stress tests would be for a bank’s own internal purposes, or if it would be released to the public where investors would be able to scrutinize the results. Here’s Lauren Anderson again.

ANDERSON: I think determining the purpose of these exercises is critically important at the outset. And unfortunately, I think in the race to try and get something done and get banks to do things and to be seen to be at the forefront of this, a lot of authorities have been approaching this with mixed purposes, and not being really crystal clear on what is it that they’re trying to do with the data or what comes out of it — the qualitative responses, etc.

DOUGHERTY: I think we need to start really soon, and it would probably be scenario analysis. There won’t be capital charges immediately, because it’s a new process. You also need to give people a little bit of a time to adjust. You’ve never been asked to base your regulation based on climate, and so in one day, you don’t maybe just change all the rules and expect banks to already be in the right place. But you start giving them the time to get the tools in place, and get that data and say, ‘Oh, my goodness, I did not even realize I had this kind of exposure to, in this example, Miami real estate or a wildfire risk-prone area.’

LANG: Some argue, however, that the Fed’s capital regime wasn’t designed to deal with longer-term risks like climate change.

COVAS: The capital framework is not the way to tackle climate change. It definitely was not designed for climate change; it was designed to deal with much shorter-term risks, and not the type of risks that we are facing with climate.

LANG: For John Cochrane from the Hoover Institute, climate stress tests wouldonlymake sense if the purpose were to levy capital requirements on certain activities.

COCHRANE: I would say if you really believe that there’s a climate risk, you should be saying lots, lots more capital, not micromanagement of the climate investments of various companies. That they’re not doing that means they don’t believe it’s a climate risk — that this is just a device to force companies to invest the way the Fed wants them to do invest.

DOUGHERTY: Over time, yes, they should work to there actually being teeth to these scenarios. Because if you are having this huge risk, especially for the largest firms — like the way the Fed does it currently is the largest 19 firms do their stress test each year, because they not only affect themselves, but they also affect the entire financial system. If one of those fails, that has a bigger effect than if a smaller institution fails.

LANG: There are also some out there that worry capital requirements or even the public disclosure of climate stress test or scenario analysis results could have unintended consequences for the financial system as a whole.

COVAS: Effectively what could happen is that that type of lending moves out of the regulated sector to the non-regulated sector, and has no impact, and it doesn’t really affect ultimately, what the policymakers want to accomplish, which is to influence or accelerate corporations’ decisions to move away from carbon-intensive technologies and to greener technology. So, but you may not be able to accomplish that, because what happens is just the lending is moving away from the banks, to nonbanks, and the banks are not going to be happy with that.

LANG: That happened with mortgage lending as well after the 2008 financial crisis as banks were made to hold on to more capital to protect from losses in that sector. As a result, in 2019, nonbanks originated almost 60% of new mortgages — up from just 10% during the peak of subprime lending.

DOUGHERTY: In general, it’s kind of frightening that how much of our financial system isn’t really regulated because of these changes. So I wouldn’t say that’s ideal for the financial system, in general, to have so many things that we just don’t have a lot of disclosure and information about.

VALLADARES: The minute that anybody says, ‘We need a regulation for capital, we need a regulation for liquidity, for culture, for behavior immediately,’ you hear, ‘Well, we shouldn’t impose that rule, because then that activity will just move out of the banking system.’ There is truth to that, sure, because regulations are not free. They’re not cheap, meaning it imposes a cost to the regulated entity. But that is not an excuse for legislators and for policymakers and regulators not to create good rules for the sake of the safety and soundness not only of banks, but of the financial system.

LANG: Something most people can agree on, however, is that something like a climate stress test would take time to come to fruition.

NEWELL: Certainly, there’s a major initiative underway at the Federal Reserve to better understand climate-related financial risks and to build their own capabilities to understand those risks and to measure them over time. My sense is at the moment, a lot of that activity is really designed to help the Fed sort of get up to speed in terms of understanding what risks may be posed, and what approach they want to take over time, where it’s probably still more at an educational and exploratory stage as opposed to a more detailed sort of action item list.

VALLADARES: I think it’s important to remember that sure, any kind of new guidance or rule or regulation that may be coming down the pipeline isn’t going to come tomorrow. These things unfortunately take time, but in a way, you want some of that time, because there should be industry feedback. Regulators need to be talking to bankers and vice versa.

LANG: But in the space between researching climate risk and launching things like stress tests to analyze how banks might be prepared for global warming, the Fed has first had to prove its own authority to even look into the issue.

COCHRANE: If you’re a central banker, and you want the applause of Davos, and to be a leader on climate change, unfortunately, you’re not in charge of the climate. There is an EPA out there, there is a Treasury Department that hands out subsidies, but that’s not your job.

LANG: Powell has spent the last year trying to make it clear, however, that it is the Fed’s duty to oversee how banks are managing their portfolios, and that climate change falls squarely in its supervisory responsibilities, although it remains to be seen if he’s managed to convince any detractors.

POWELL: We supervise banks and some other institutions to assure that they’re understanding and are managing the risks that they’re running in their business, and we don’t have a new mandate, that’s what we do, and climate change is an emerging risk.

DOUGHERTY: I think people sometimes forget that this stuff started before Biden took office, especially at the Fed. I think that’s really important that this is not a political thing. This is based on research and analysis, that this is a risk to the Fed’s goals and mission.

VALLADARES: Very specifically under Basel 3, pillar 1, banks are supposed to identify, measure, control and monitor operational risks, and that means, you know, how can a fire affect my bank? How can a flood, how can a hurricane, how can an earthquake? That’s already there under external events. It, unfortunately, is really misguiding the public when any kind of legislator says that the Fed, FDIC or OCC doesn’t have the power to do this. It is for the health of not only the banking system, but frankly of the entire financial system of the United States.

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