While Jerome Powell and the Federal Reserve ponder continued interest rate hikes to combat inflation, another central bank is making news for fighting a different enemy – climate change. The European Central Bank (ECB) conducted its first climate stress test this past year, and the results were less than optimal. In a report published by the ECB in July 2022, they determined that “banks do not yet sufficiently incorporate climate risk into their stress-testing frameworks and internal models.” Climate change has long been a real threat to our planet, and it is past time for banking regulators and the rest of the industry to take the steps to combat climate change. While the ECB report may seem bleak, it shows there are tools the Federal Reserve can use to bring our country’s largest banks into the fight to save our planet.
Since the passage of large-scale regulatory frameworks like Dodd-Frank, the largest U.S. banks are now managing data on future risks in the hopes of avoiding another financial crisis. U.S. banks perform regular stress tests, overseen by the Federal Reserve, to understand where there are risks in their portfolio and how best to mitigate them. The new ECB methodology shows the same idea can be applied to better assist banks in hopes of reducing the financial and environmental risks from climate change.
While some banks have voluntarily adopted (and failed to meet) new Environmental, Social, Governance (ESG) goals to combat climate change, the Federal Reserve has the power to compel these banks to make more climate-conscious decisions. By developing standards and tests for banks’ climate risk, banks can change their investment strategies to include pre-identified climate risks.
One hypothetical example is that of a bank holding a large portfolio of loans and other assets in gas stations. While there may not be any immediate risks presented in current stress tests, the shift towards the production of electric vehicles from major U.S. car manufacturers presents what would be a “transitory risk” to this bank’s portfolio. As the economy transitions away from fossil fuels to be more climate-friendly, banks must change how they invest their assets to keep pace with the changing automobile demand.
Another example can be seen when a bank holds a large portfolio of real estate loans on low-lying coastal regions. Recent EPA reports show many regions are expected to experience higher rates of overall rising sea levels, storm surges, and flooding. These environmental factors present increased “physical risks” to a bank’s assets and investments and will likely have an impact on secondary insurance markets. When these risks are included in stress testing, banks must rethink their investment strategies to account for the effects of climate change.
Climate stress testing is not a negative for the banks. By accounting for the transitional and physical risks posed by climate change, they can shift their capital towards technology and infrastructure investments that prepare and drive society towards a better planet. The necessary first step is to encourage the Federal Reserve to include climate scenarios in their stress tests. If we are going to truly combat climate change, we need all sectors to do their part. The Federal Reserve and Jerome Powell have the means to adapt existing frameworks, such as Dodd-Frank, and join the fight to secure a strong and sustainable planet for future generations. We are overdue for action, and we must put our money where our mouth is in the climate change fight.