The Federal Reserve Board has announced that six of the largest banks in the US will participate in a pilot climate scenario analysis exercise to be launched in 2023. The pilot will aim at providing insights on how banks measure and manage climate-related financial risks, potentially informing future guidance for other supervised financial institutions.
Further guidance from the FRB is to be issued in early 2023, including details of the climate, economic and financial variables that will make up the scenario narratives. But the general expectation is that the exercise will be influenced by what has been mandated by other regulatory bodies across the globe such as the European Central Bank, the Bank of England and the Hong Kong Monetary Authority. Globally, central banks are focusing on counterparty-level bottom-up scenario analysis for high emitting sectors and largest exposures using NGFS-based scenarios modelling for both Physical and Transition Risks across multiple time horizons including a long term one (30 year).
In 2021, the Bank of England went through an in-depth stress test focused on climate change: the CBES. Many of the same factors are at work and will no doubt inform the FRB approach. Baringa partnered with 11 of the 18 CBES participants in providing them end-to-end support to complete this exercise. Based on our experience, we have distilled six key learnings for financial institutions to consider as they prepare for the FRB Scenario Analysis exercise. Even if your institution isn't in scope for this first exercise, you should get started so you are ready for subsequent exercises.
1. Start now
It will take time to build up to running a full scenario analysis at scale. As we have done with many of our clients, we recommend starting with a small-scale pilot to support developing your data sourcing strategy, progressing to a full-scale dry run to enable you to test and refine your implementation ahead of the final ‘live’ run. As it’s already September, time is already running short.
2. Use the FRB scenario analysis exercise to accelerate your strategic climate scenario analysis solution ...
Do not see the FRB exercise as a one-off exercise, but use it to build capability and to progress the implementation of climate risk management into the organization. Taking this approach has enabled many of our clients to keep up with the climate change progress being made by competitors and the growing pressure from shareholders to manage climate risk and temperature alignment.
3. ... and to accelerate your climate data sourcing strategy
Climate change scenario analysis requires a lot of granular counterparty-specific data not commonly held by banks. You will need a strategy for addressing these data gaps e.g. counterparty engagement, use of third party data providers, and implementing proxies for residual counterparts. We have found that addressing the data gap on unlisted counterparties is a large part of the effort, usually taking far longer than expected – especially as 75% of the counterparties in a typical corporate banking portfolio are unlisted.
4. Engage key stakeholders across the organization early on
This exercise is an opportunity to accelerate the high-quality dialogue and capability building around climate risk and net zero across a wide range of stakeholders (including Risk, Finance, Front Office, Sustainability and Technology). By running Climate Change Education and Scenario Outcome Review sessions with Executive Teams, Sector Leadership teams and Risk Boards/Committees at our clients, we have helped build understanding of the drivers of climate change and the specific impact on portfolios, sectors, geographies, counterparties and assets classes.
5. Clearly articulate the strategic value of climate scenario analysis with all stakeholders
30-year scenarios are inherently exposed to significant model risk, and the outputs should not be interpreted as predictions. However, many of our clients have found that climate scenario analysis can be a very powerful technique for creating material separation between the potential ‘winners’ and ‘losers’ from climate change, and therefore for identifying concentrations of risk in a portfolio, identifying potential opportunities, and informing portfolio strategy. The real value of granular and sector and counterparty–specific outputs will be to provide you with actionable insights, which you can use to drive your business strategy and portfolio decision making.
6. Allocate significant time and resource to the qualitative components of the exercise
The exercise should stimulate the development and embedding of new risk management capabilities within firms’ business-as-usual processes. We have helped our clients use the scenario analysis outputs to accelerate their thinking on how to embed climate risk in their enterprise risk management framework e.g. portfolio reporting, Board Risk Committee engagement, annual credit reviews, and risk appetite. Using scenario analysis results can inform your climate risk framework development and accelerate your strategic embedding.
Under the current FRB mandate some of the largest US financial institutions will start preparing their climate change scenario analysis but the other banks shouldn’t delay, especially given the Security Exchange Commissions (SEC) has proposed regulations to introduce and standardize climate-related disclosures for investors, including climate risk management and the use of scenario analysis. If you would like to learn more about how we help our clients to embed climate risk and use Scenario Analysis capabilities, please contact Hortense Viard-Guerin.