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ESG focus: Fed plans transition stress tests for banks

US Federal Reserve Joins Push to Test Banks for Climate Risks; a push that will force banks to potentially set aside trillions of capital; put additional pressure on fossil fuel producers; and help develop macro and microeconomic knowledge on the transition to shape policy responses.

-The capital deficits of some banks will be significant
-Bank risk to be coupled with country risk
-The emphasis is on transition risk rather than physical or liability risks
-APRA releases latest information on banks climate vulnerability assessments

By Sarah Mills

The US Federal Reserve in New York, which is the financial manager of the Federal Reserve and the US Treasury, has released a stress test template for major banks’ weather exposures.

If applied, the model will likely force banks to set aside more capital to support their oil and gas assets, which will increase the cost of capital to hold fossil fuel assets.

Morgan Stanley estimated that these capital shortfalls will, for some banks, “economically substantial”.

Using a bank as an example, Bank dive estimates that the amount of capital that Citi should set aside as part of the CRISK (Systemic Climate Risk, which is the expected capital shortfall of a financial institution under a climate stress scenario) has climbed to $ 73 billion last year.

Steps to implement weather stress tests for banks are already underway in other countries, long before the Fed, as Europe strives to lead the global transition and establish market dominance in a new energy order.

The Network of Central Banks and Supervisors for Greening the Financial System comprises 89 member countries.

The cost to banks of setting aside additional capital could be passed on to fossil fuel companies, adding higher funding costs to the risk of stranded assets for fossil fuel shareholders.

Alternatively, banks could spread taxes on capital across the banks’ larger portfolios, or banks could internalize the costs, affecting the profits of bank shareholders.

Either way, it would suggest increased costs for businesses and consumers until the transition is complete.

But bank stress tests are unlikely to happen anytime soon, with Morgan Stanley noting that the document’s findings are expected to be implemented between 2023 and 2025.

The Fed’s research paper sets out a method for identifying assets vulnerable to climate shock, and then calculating the capital shortfall that is likely to result.

Banking risks to be coupled with country risk

Bank dive reports that the document also highlighted the likelihood of reallocating or coupling CRISK at the bank level to CRISK at the national level, increasing pressure on governments to regulate the climate and providing more in-depth macroeconomic information as the risks transitions extend to most sectors of the economy.

Lagging sovereigns would likely experience rating downgrades and higher funding costs.

Unsurprisingly, Federal Treasurer Josh Frydenberg recently warned that Australia has a lot to lose if we do not transition quickly, paving the way for Prime Minister Scott Morrison for COP26 in Glasgow.

“Australia has a lot at stake,” Frydenberg said in a speech to the Australian Industry Group. “We cannot run the risk that the markets mistakenly assume that we are not transitioning with the rest of the world.”

The paper only examines transition risks and notes that the risks are systemic

Climate change affects banks in two main ways: transition risks associated with government climate regulation; and physical risks to bank assets such as floods and drought. Liability risk is also a threat.

The paper discusses transition risks, not physical risks, but Reuters reports that the latter could be addressed in the future. Transition risks are easier to verify than physical risks.

The Fed applied the model to 27 of the world’s largest banks, which provide 80% of loans to oil and gas companies.

The authors of the article found that while the effects on individual banks varied, they were strongly correlated, indicating systemic risk.

While this conclusion may seem obvious, the document represents the first step in a process.

The paper found that climate risk also tends to evolve in tandem for major banks in the US, Canada, UK, France and Japan.

The research described a measure of transition risk, using returns on stranded asset portfolio as an indicator of transition risk, as well as the likely effects of regulations such as carbon taxes.

The authors propose a measure called CRISK: the expected capital shortfall of a financial institution in a climate stress scenario; and notes that this measure increased sharply in 2020.

This is not surprising given the breathtaking punch that covid delivered to oil price volatility last year. It is not known whether the CRISK measure reflects this non-climate bias.

Morgan Stanley reports that CRISK is calculated based on company size, leverage, and expected loss of capital due to climate stress.

The news from the Fed will come as no surprise to banks, which have been examining their portfolios for weather exposures for years, given that the writing has been on the wall.

APRA calls on five largest banks to conduct risk assessments

In early September, the Australian Prudential Regulation Authority released details of the Climate Vulnerability Assessments (CVA) that Australia’s five largest banks are conducting in response to APRA’s appeal in April (the Big 4 and the Macquarie Bank ).

Given that Australia is a fossil fuel-based economy, one imagines that the amount of money banks will need to set aside in Fed scenarios will be substantial.

CVAs require banks to report on the financial impact of the climate on income statements, cash flow statements and balance sheets.

APRA said CVAs could also apply to the pension and insurance industries and could be of use to other non-financial businesses in Australia.

APRA adds liability risk to transition risk and physical risk in its assessments.

A link to the Fed paper is available here: https://www.newyorkfed.org/research/staff_reports/sr977

A link to the APRA document is here: https://www.apra.gov.au/climate-vulnerability-assessment

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