The Fed is finally asking questions about climate risk for banks. But we still don't have answers.

Climate risk is making it into the headlines more frequently, signaling its growing importance across the economy and society. But what does climate risk mean for banks and the financial system? At its core, climate risk refers to the potential financial losses and instability caused by climate change, encompassing both physical risks (storms, floods, and wildfires) from extreme weather events and transition risk (regulatory changes, market shifts leading to stranded assets, and technological advancements) from the shift towards a low-carbon economy. As climate change accelerates, the integration of climate risk into financial decision-making is not just a necessity but a critical step towards ensuring long-term economic resilience.

The Federal Reserve Board (Fed) released its climate scenario analysis for the six largest banks in the United States in May of this year. If you missed it, you weren’t the only one, as the Fed released it quietly almost a year and a half after putting out the original participant instructions. The questions posed to these banks centered on determining if the banks manage climate risk well and if they collect enough of the right information. The answer is largely: hard to say. Each institution has its own way of figuring out its climate risk exposure, deciding which hazards to model, and what governance structures to use but they all struggle to access consistent and relevant data.

There are several reasons why data is difficult to obtain, including the complexity of compiling it and of determining what data is relevant, as well as the fact that not all corporations are required to collect it. If financial institutions start to require their clients to report data and the Fed calls for consistent climate risk monitoring – including beyond the largest banks - these issues can be overcome. Both need to occur. The Security and Exchange Commission (SEC’s) climate disclosure rule remains in litigation limbo but should provide some clarity for some climate reporting, though as the SEC does not require scope 3 reporting, imperfect data and reporting will continue.

It is important that the Fed ask questions about climate risk and that the banks are prepared – or at least that they are more aware of whether they are – to answer them. Banks were asked to model extreme hazard events (e.g., hurricane, wildfire and/or flooding) in a geographic region to which the bank has significant exposure with and without an insurance market to manage the risk. These scenario analyses should be common practice by now because these extreme weather events are becoming more commonplace. The bigger question is – are they?

The Fed’s summary was a kind of tepid book report of the banks’ scenario analysis. It invites more questions than concrete answers and actions. What comes next? What changes need to happen? Should there be a standardized process for determining and reporting these risks? In fact, Fed staff have listed data the largest banks produce in their own attempt to see how banks are assessing climate risk in a white paper, but won’t go so far as to say that these data are sufficient to assess climate risk. European banks have assessed transition risk more often than U.S. banks, in large part because their Central Banks are conducting more climate stress tests. As the Fed has an economy-wide view of these kinds of risks, what actions should the Fed take to minimize climate shocks to the economy? Certainly there’s more it can do to shore up the financial system, account for climate risk, and benefit the economy.

Let’s be clear: larger banks are more diversified than smaller, regional institutions and are therefore more able to manage climate-related risk. They were also the only ones subject to the Fed’s scenario analysis pilot. But the financial system is comprised of more than big, multinational banks. Medium-sized and regional banks also have significant exposure to climate risk. The FDIC shows that community banks held 30 percent of commercial real estate loans in 2019 and small banks in the Midwest hold a larger concentration of agricultural loans than multinational banks. These smaller financial institutions play an important role in regional economies and if they fail, communities will suffer. If a regional bank has significant exposure to mortgages in flood-prone areas, how is it mitigating that risk? Or if a commercial bank has significant transition risk because it lends primarily to the oil and gas sector, how can that be effectively mitigated? The Commodity Futures Trading Commission (CFTC) recommends providing oversight to these risks, and I tend to agree.

Banks play a crucial role in the economy by providing loans, managing investments, and supporting businesses. Climate risks can threaten their stability and ability to function effectively. By understanding and managing these risks, banks can: ensure they remain financially viable, protect their clients and investments, and contribute to the global effort to combat climate change by supporting sustainable practices and projects. These sustainable practices and projects are profit-making investments and would avoid stranded assets, so this is just good financial practice – far from charity. By managing these risks effectively, banks can ensure smoother sailing through uncertain waters, protecting not only their assets but also the broader economy and society. It’s time that the Fed step up and take a stronger leadership role in helping the economy – and consequentially people and nature too – weather increasingly expensive and catastrophic climate risks.