Overview of FRB and U.S. prudential regulatory activity

After an initial lag, the U.S. prudential banking regulators have started to address climate risk management in recent years, gradually catching up with their international counterparts. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and FRB have released drafts of climate risk management principles that are closely aligned, and the FRB’s most recent guidance is a strong indicator of what the final interagency guidance will include. The FRB announced a pilot CSA exercise for the top six U.S. banks in September 2022, with instructions made public in January 2023, offering a glimpse into the broader guidance forthcoming. Meanwhile, the SEC is expected to finalize its climate disclosure rule by 2023. The U.S. prudential banking regulators will require banks with over $100 billion in total assets to conduct CSA. Even banks that fall below this threshold can benefit from the pilot instructions as they build their CSA capabilities.

One unique aspect of the FRB’s proposal is a brief commentary on the connection between executive compensation and climate risk management practices. The proposed principles cover six areas, including: governance; policies, procedures, and limits; strategic planning; risk management; data and reporting; and scenario analysis. It also identifies six proposed risk management areas: credit risk, liquidity risk, financial risk, operational risk, legal and compliance, and non-financial risk, all of which include climate risk as a transverse risk. Banks need to define meaningful climate risk thresholds and develop plans to identify, measure, and monitor these in each risk area.

The FRB’s pilot exercise involved two modules:

Physical risk: To determine the probability of default and loss given default rates for six different scenario analyses based on real estate portfolios

Transition risk: To analyze the impact of climate change on commercial real estate (CRE) and corporate loan portfolios over 10 years.

This exercise also required banks to provide non-numerical information on governance and risk management, measurement methodologies, model risk management, and lessons learned. Based on the findings of this pilot (due July 31), the FRB plans to release official guidance.

Physical risk module

The FRB assesses potential impacts on a bank’s portfolio through the physical risk module. This module considers scenarios based on global greenhouse gas emissions and temperature changes. The pilot primarily focuses on acute physical risks such as hurricanes, and requests that banks evaluate the impact of these shocks on their real estate portfolios (considering both insurance coverage and non-coverage). 

The idiosyncratic shock component involves banks selecting a hazard and a national climate assessment region (excluding the northeast region) supported by a qualitative rationale for the selection. The impact estimates should cover both residential and CRE portfolios with different insurance assumptions like in common shocks. Banks should focus on a one-year projection for risk parameters aftershocks are realized. The credit estimates impact should be evaluated at a loan or facility level, and the parameters considered should include the probability of default and the internal risk rating grade for CRA loans.

Transition risk module

The FRB has selected two climate scenarios from the Network for Greening the Financial System (NGFS) to assess the impact of climate-related transitions on corporate lending portfolios and CREs. The two scenarios are NGFS current policies and net zero by 2050. Participants are required to estimate the relevant risk parameters for each applicable loan annually. Both scenarios include macroeconomic and energy transition variables at the global and regional levels. The current policy scenario assumes no changes in policies are introduced, whereas the net zero by 2050 scenario requires immediate introduction of stringent climate and energy policies, with longer transition risks. The net zero scenario also includes direct CO2 removal, while the current policy scenario uses renewable CO2 technologies. Regional policy variation is more prevalent in the net zero scenario.

The FRB’s credit estimation methodology for transition risk differs slightly from physical risk. It has a 10-year projection horizon and requires climate-adjusted credit parameters calculated annually based on the asset position held on December 31, 2022. With the 10-year projection period, the FRB set some key guidance on the balance sheet approach and other loan characteristics for the exercise.

• Banks should use a static balance sheet approach, holding constant the size and risk characteristics of the balance sheet as of December 31, 2022, over the projection horizon.
• Banks should hold constant the residual maturity of each exposure across the horizon. Exposures should not mature or amortize. Where time-to-maturity is deemed relevant, banks should hold constant the loan payment schedule, and assume the time-to-maturity of the fixed schedule remains constant.
• “Defaulted” exposures should not be effectively written off and removed from the exposure universe. If an estimated exposure RRG transitions to the terminal rating grade associated with defaulted obligors, banks should report the exposure within the loan population and fix future RRG (PD) projections at the terminal rating grade.

How to perform the transition risk module

The transition risk module involves four major activity areas:

• Data collection, including NGFS scenario data and macroeconomic and low carbon energy transitions
• Expansion and downscaling of the scenarios to model additional market indicators at the appropriate scale
• Segmentation and transmission channels that involve adjusting credit parameters for climate-related risks, and identifying transmission channels for different sectors
• Developing climate-adjusted credit models with the required parameters.

To start the journey towards assessing transitional risk, key elements include conducting risk assessment, maturity assessment, and understanding weak spots in the portfolio. This allows a better understanding of transmission channels and sensitivity to factors such as carbon prices and energy mixes.

Lessons learned from the EU and UK climate scenario analysis exercises 

Global regulators have increased their focus on climate risk for the past two to three years, with many conducting stress testing exercises. These are conducted by local regulators, the ECB, and the UK, and cover physical and transition risk over a 30-year period using three NGFS scenarios.

Climate Biennial Exploratory Scenario (CBES)

The Bank of England’s stress testing exercise covered seven of the top UK banks and focused on the three NGFS scenarios over a 30-year period. Climate-related credit losses were projected to be more than double in the late action scenario that resulted in an extra £110 billion in losses for participating banks over that period.

Key challenges included:

• Modelling capabilities, as it was an unfamiliar area and banks lacked the necessary expertise
• Non-availability of data for physical risk hazards, and for counterparty transition plans to be included in stress testing.

Next steps:

• More sophisticated and nuanced approaches to risk management must be developed
• Banks should align assumptions to their business model specificities
• Banks should consider the impact on economic capital calculations.

ECB –Climate Risk Stress Test (CST) 2022: Results

The ECB stress testing exercise consisted of three modules: a qualitative question, peer benchmarking, and stress testing. The exercise covered these three scenarios over two years and included a short-term scenario. It showed that the late policy scenario resulted in more credit losses than the early policy scenario. Data was the major challenge for banks, particularly the EPC data in Europe.

The ECB will include the exercise findings in banks’ supervisory letters and banks will need to include climate risks within their Internal Capital Adequacy Assessment Processes (ICAAPs).

KPMG service offerings

Banks participating in the pilot are far along in this climate risk management and quantification journey. KPMG can support organizations in this end to end: climate risk management efforts starting with risk identification and exposure assessment, data identification, quantification, analysis, and communication. Our ESG delivery teams are powered by dedicated advisory data teams, KPMG third-party data, and internal data assets. With more than 10 ESG analytics solutions and over 40 analytics and solutions accessible on a self-service platform, KPMG is well positioned to support your climate risk management journey.

Closing comments

Assessing and managing climate risk is an area of sharpened focus for banks and is critical to ensuring long-term sustainability of the business. Scenario analysis is key to evaluating a banks' resilience to climate-related matters and allows them to improve decision-making in the face of uncertainty. Many financial institutions are referring to ongoing or upcoming resilience and stress testing exercises from their regulatory bodies, as well as outlining the steps they are taking towards a more holistic scenario analysis.