Financial firms need to ensure they can weather the storms of climate change. (Photo by Ben … [+]
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In September 2008 the financial industry imploded. Markets from New York to Hong Kong seized up in panic. Headlines testify to the suddenness of that fateful month’s events. September 7: “US housing crisis: Freddie and Fannie are nationalized.” September 14: “Lehman Files for Bankruptcy; Merrill Is Sold.” September 17: “A.I.G.’s $85 Billion Government Bailout.” September 22: “Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid to Ride Out Crisis.” September 29: “Dow posts record point drop as House rejects bailout.”
The financial collapse shook the entire global economy. From Ireland to Iowa, years of expansion came to an abrupt halt. Within the U.S., millions lost their jobs as unemployment soared above 10%. Countless families lost their homes, their savings, or both. Major market indices fell by nearly 50%. The Government Accountability Office estimated that the crash had cost America over $22 trillion in lost wealth, lost wages, and lower growth.
Enter stress testing
Reflecting on the carnage, financial regulators realized key warning signs had been missed. How had apparently healthy, well-capitalized financial institutions gone into such distress? Clearly, previous assessments of financial stability were inadequate. Regulators needed a process that would enable them to identify risks to the financial system and to individual firms. Enter stress testing.
Today, although stress testing practices vary across geographies, they all focus on maintaining financial stability. Regulators want to ensure that financial institutions are adequately capitalized for the next crisis. To accomplish this, regulators develop a set of macroeconomic scenarios. Firms evaluate their portfolios against these scenarios (and create their own scenarios as well). Portfolio model results are aggregated to demonstrate how the firm would fare under economic stress. Regulators then assess these results to determine whether the financial system or individual firms are undercapitalized. Institutions that “fail” stress tests may be forbidden from issuing dividends or expanding their businesses. Failure can also have reputational and financial impacts in the market. These incentives have produced a significantly better capitalized global financial system.
Climate change: The next crisis
As one can never be certain where the next crisis will originate, firms must be resilient to a variety of economic pressures. However, the financial industry has increasingly acknowledged the unique disruptive potential of climate change. In his annual letter, Blackrock CEO Larry Fink stated: “I believe we are on the edge of a fundamental reshaping of finance.” Bank of England (BoE) Governor Mark Carney declared that “companies that don’t adapt [to climate change] will go bankrupt without question.” A recent paper by the Bank of International Settlements (BIS), responsible for the Basel financial regulations, warned of a “green swan event,” describing climate-driven financial destabilization.
Regulators want to know how the financial system will weather the storm of climate change. Stress testing already provides effective tools to evaluate financial stability. Thus, it makes sense that some existing stress testing machinery could be adapted to climate risk assessments. Indeed, several regulators have announced plans to create climate stress tests or expand existing ones.
Carney’s BoE has offered the most ambitious testing proposal to date. Their stress test has three objectives: sizing exposures of individual firms and the financial system to climate risks, understanding responses to climate impacts, and improving firms’ climate risk management. The exam would consist of two parts. In the first part, firms would quantify asset value changes over the course of a scenario. In the second part, firms would detail how their business models would adapt to climate risks. For the initial run of the exercise, no capital requirements or penalties would be enforced on firms.
The BoE’s climate stress test differs from traditional stress tests in several important ways. Three scenarios related to climate action policies would be provided: an early policy response, a late policy response, and no policy response. Like traditional stress tests, the climate stress test would include scenario forecasts for macroeconomic and financial variables. However, the climate stress test would also integrate climate variables such as emissions and temperature changes into the scenarios. Another area of difference is the time horizon. As many climate impacts may take time to fully manifest, the exercise would have a 30-year horizon, far longer than the 2-5-years seen in traditional stress tests. Finally, firms would need to assess the vulnerability of individual counterparties to climate risk. Counterparty modeling makes the exercise far more granular and data intensive.
The BoE climate stress testing proposal is not finalized, and comment period runs until mid-March, allowing industry participants to weigh in. Early industry feedback has raised concerns with the time horizon and the level of modeling granularity. The BoE may yet alter these or other aspects of the exercise. Regardless of the final form, the BoE stress test reflects a major step up in regulatory expectations on climate risk.
The way forward
BoE’s leadership owes much to the vision of its outgoing governor. In 2015, Mark Carney and Mike Bloomberg helped the Financial Stability Board (FSB) launch the Task-force on Climate Related Financial Disclosures (TCFD). The TCFD provides a set of climate disclosure guidelines to enable markets to better account for climate risk. In 2017, a group of central banks and supervisors came together to form the Network for Greening the Financial System (NGFS). NGFS now includes over 50 global members who are developing guidance around climate risk assessment and scenario analysis. These initiatives will provide valuable frameworks for other regulators looking to evaluate climate risks.
At present, climate stress testing practices remain in their infancy. Firms need to make decisions on incorporating climate factors into financial projections, modeling long time horizons, and assessing the climate risks of individual counterparties. However, many financial regulators express a growing desire to better understand climate risks. As a result, the industry should anticipate the roll out of further climate stress tests in the coming years.