Fed's Climate Scenario Analysis Reveals Data Gaps, Modeling Challenges for US Banks

The Federal Reserve released results of a pilot climate scenario analysis with six largest US banks, highlighting significant data and modeling challenges in estimating climate-related financial risks. The analysis revealed difficulties in modeling risks due to data gaps, despite being highly simplified and streamlined.

Nitish Verma
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Fed's Climate Scenario Analysis Reveals Data Gaps, Modeling Challenges for US Banks

Fed's Climate Scenario Analysis Reveals Data Gaps, Modeling Challenges for US Banks

The Federal Reserve has released the results of a pilotclimate scenario analysisconducted with the six largest banks in the US, including JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, and Wells Fargo. The long-awaited analysis aimed to assess the banks' capacity to consider climate-related financial risks and revealed significant data and modeling challenges in estimating these risks.

The analysis, which required banks to test their ability to model and withstand climate change impacts, highlighted that the banks faced substantial difficulties in modeling climate-related financial risks due to a lack of access to data. The banks have yet to build out internalmodels of howclimate change will impact their businesses. Despite being highly simplified and streamlined, the exercise still exposed deep issues in measuring climate-related physical and transition risk to banks.

Why this matters: The ability of US banks to accurately model and prepare for climate-related financial risks has significant implications for the stability of the entire financial system. Failure to address these risks could lead to widespread loan defaults, infrastructure damage, and economic instability.

The analysis found that a severe hurricane in the Northeast US in 2050 could impact nearly half of five banks' combined residential real estate loans in the region, potentially triggering loan defaults. Both natural disasters and the clean energy transition pose risks for the banking industry, including increasing the likelihood of loan defaults. Banks struggled with parts of the analysis due to significant data gaps around property insurance coverage and building characteristics.

Mekedas Belayneh, Policy Advocate with Public Citizen's Climate Program, commented on the analysis, stating,"Results of the Federal Reserve Board's pilot climate-related exercise underscore just how difficult it is to measure highly uncertain climate-related financial risks, despite knowing many of the risks will materialize... The radical uncertainties and existential threat posed by climate change render traditional financial modeling frameworks inadequate to mitigate climate risk."

The analysis comes years after climate advocates and the Biden administration called on financial regulators to consider climate change's potential to upend the US financial system. President Joe Biden signed an executive order in 2021 calling on his administration to address the financial threats of climate change. However, the Fed's decision to pursue climate-related scenario analysis sparked opposition from Republican lawmakers who claimed financial regulators do not have the authority to wade into climate issues.

The Fed emphasized that the scenario analysis exercise will have no regulatory implications for banks and that the central bank cannot and will not dictate which industries banks do business with. The Fed stated, "The Federal Reserve neither prohibits nor discourages financial institutions from providing banking services to customers of any specific class or type, as permitted by law or regulation."

The Federal Reserve's climate scenario analysis underscores the complicated nature of modeling future natural disasters and the clean energy transition, and what both mean for the world's largest banks. The report aims to help banks and regulators pinpoint, monitor, and address climate risks as they develop. Advocates recommend that the Federal Reserve implement precautionary measures, such as transition plans, to mitigate the severe but difficult to model financial risks related to climate change. They also suggest regulators incorporate qualitative approaches to fill in modeling and data gaps and work with climate scientists in the design and review of scenarios to ensure models align with climate science.