What does climate scenario analysis mean for all US financial institutions?

At the beginning of this year, the US Federal Reserve released the details of its pilot climate scenario analysis exercise for the nation’s six major banks. This exercise requires some of the key players within the US’ financial sector to assess the magnitude of climate change’s impact upon their respective organizations by July 31. In our latest blog, Maureen Maguire, Head of US Market from the Climate & ESG Solutions team explores the overall implication this could have for other smaller banks and financial institutions.

When speaking to financial institutions over the last couple of months, I am struck by how many, regardless of whether they are being required to perform scenario analysis, are now actively assessing the potential impact of climate change on their portfolios. Some are undertaking this task with a large climate team but others with just a team of one. Some see the issue of climate change solely as an operational risk, whereas others are taking a layered approach to climate risk by incorporating tipping points and market risk. As we learn more about the complexities of climate change, it is becoming apparent that there are many known, unknown and layered risks that should be integrated into scenario analyses where possible.

The recent risk event witnessed by the global financial sector has taught us about the power of layered risks. Prior to March 10, 2023, a bank failure would have likely been perceived by many as a low probability risk. When this risk was realized, it took as little as two days for it to shutter the 16^th largest bank in the US, making it the largest bank run in history. While the risk of a rising interest rate was known, it was an unprecedented combination of risks that finally raised the alarm for this specific institution before it was seized by regulators. The risks were always there, we just couldn’t see them. Carefully constructed scenario analyses allow financial institutions the opportunity to understand the impact of risks and possible aftermath and prepare for the risk before it becomes too late.

A quick turn in market sentiment, like the one recently witnessed, is a concern when modeling climate scenarios. Incorporating market risk that reflects a sudden awareness of climate risk not being priced into an asset can have a detrimental effect on the value of a company or a portfolio. What makes it more difficult is that many traditional financial modeling approaches have been slow to incorporate climate change-related market risks within scenario analysis. This has led to the emergence of climate scenario analysis – a great structured tool that enables financial institutions to understand better how climate change may impact their portfolios.

Another risk that is now commonly discussed is group-think. While financial institutions are focused on utilizing a set of climate scenarios with plausible outcomes, there could be some significant ramifications in the event that another entirely different scenario eventuates. Bespoke, idiosyncratic or alternative scenarios are constructed to incorporate specific risks which would severely impact an institution based on its own business model, portfolio or footprint. This is what financial institutions should be exploring. Financial institutions with assets that are located in flood, drought and wildfire-prone areas should consider constructing climate scenarios or using alternative climate scenarios to help them understand how these climate change-related events can impact their institutions.

The signal that comes from this regulatory requirement is that climate change may create a financial impact and that US financial institutions, no matter how big or small, should incorporate risks arising from climate change into their investment strategy, decision-making and enterprise risk management frameworks. Not being able to fully determine how much of an impact is something that financial institutions will need to continue to explore and manage as data and models improve, but they can certainly focus on gaining a clearer understanding of the potential ramifications.

While large, diversified global banks may not be brought down by a single climate event, layered events could serve as tipping points. Mid-size and smaller, unprepared financial institutions with less diversification could be at risk. Banks have painfully learned that their customers are just a click away from transferring their accounts to a different institution – perhaps to one that takes climate change into account so they may feel safer.

Learn more about our Climate Scenario Analysis Solution - ClimateMAPS