Although the transmission channels through which climate risks affect banks are increasingly apparent, quantification of those risks remains challenging. To date, measurement efforts have been hampered by data gaps and methodological hurdles, many of which are unique to climate change and contribute to elevated uncertainty in estimates of climate-related risks. For instance, assessment of the potential impact of climate change on a bank may require precise data on the geolocation of a counterparty's assets and operations, as well as information on local weather patterns for those locations. It may also require knowledge of a counterparty's carbon emissions and of policies in different industries and jurisdictions. Data at this level of granularity are often unavailable or extremely difficult to acquire, presenting challenges in calculating the magnitude of climate-related financial risks. Two-thirds of respondents to a recent survey of members of the Basel Committee on Banking Supervision's Task Force on Climate-Related Financial Risks (TFCR) indicated that they lack sufficiently granular or reliable data necessary to run climate risk assessment models.22
Filling these data gaps is critical for measuring the banking sector's exposure to climate risk and analyzing the implications for financial stability and prudential risks. Federal Reserve staff are participating in a new Network for Greening the Financial System (NGFS) workstream on "Bridging the Data Gaps." The workstream will create a detailed list of gaps in data items at the macroeconomic level, the market level, and the financial market participant level needed to model climate risk.23
Climate change also poses distinct modelling challenges. The several decades over which climate risks are projected to materialize far exceed a bank's typical risk management and planning time horizon. Moreover, financial risk models are often backward-looking and extrapolate historical trends, which, in the case of climate, may be unreliable predicators of future outcomes. New tools and forward-looking approaches will be required.24
We continue to strengthen our understanding of how banks are measuring and managing climate risks. Over time, it will be important to develop a framework for evaluating how banks are taking into account climate-related risk in their modelling and management of credit, market, liquidity, and operational risks. Some jurisdictions have developed programs to provide banks with supervisory expectations to manage their risks associated with climate change.25 As a financial industry association has noted, "Climate risk analysis and measurement is—rightly—rising quickly on both the industry and regulatory agenda. Both regulators and firms want to better understand risk profiles to ensure effective management of transition and physical risks as well as potential adequacy of financial resources."26
We benefit from continued engagement both domestically and internationally with colleagues from other regulatory agencies, supervisory authorities, and international standard setting bodies. For instance, the Federal Reserve co-chairs the Basel Committee on Banking Supervision's TFCR.27 The TFCR is mapping the transmission channels and studying the measurement methodologies of climate-related financial risks to the banking system. It will also examine the extent to which climate-related financial risks are incorporated in the existing Basel Framework. Based on this analysis, the TFCR is charged with and is developing recommendations for effective supervisory practices to mitigate climate-related financial risks.28
Climate Change and Community Reinvestment
Financial institutions can also help communities and individuals build greater resilience to climate risk. Recent research highlights the significant ways in which lower-income households and underserved areas are affected by natural disasters and climate risk.29 Lower-income households with low levels of liquid savings tend to be less resilient to the temporary loss of income, property damage, displacement costs, and health challenges they face from disasters.30 In addition, low- and moderate-income (LMI) communities are often located in areas that are particularly vulnerable to climate-related risks, have greater health-related impacts due to climate change, or have housing that is more susceptible to disaster-related damage.31
Under the Community Reinvestment Act (CRA), banks have an affirmative obligation to meet the needs of their local communities, including LMI communities. Existing CRA regulations allow banks to receive CRA credit for activities to revitalize and stabilize communities after a natural disaster has occurred in certain federally designated disaster areas.32 For natural disasters that have caused widespread devastation and economic impact, such as Hurricanes Katrina and Maria, the Board has worked with other banking regulators to provide CRA consideration for bank investments in stabilization and revitalization outside of a bank's assessment area or regional area.33
It is important to LMI communities and other underserved communities to be proactive in working to equitably mitigate the risks of climate change in advance. Reflecting this, the Federal Reserve's recent advance notice of proposed rulemaking on the CRA for the first time seeks feedback on providing CRA credit to encourage loans and investments that promote disaster preparedness and climate resilience.34 We want to encourage lenders to invest and rebuild in ways that will increase resilience to future climate risks in underserved and local LMI communities. We look forward to receiving comment on our questions regarding disaster preparedness and climate resilience by the February 16, 2021, deadline.35
Looking Ahead
A year ago, I laid out some of the important areas where climate change matters for the Federal Reserve's statutory responsibilities.36 The Federal Reserve has been making important progress in laying the groundwork to incorporate climate considerations where they are material and relevant to our statutory responsibilities, today and in the future. Across the Federal Reserve System, we have sought to deepen our understanding of the implications of climate change for the U.S. economy and financial system, including through the Virtual Seminar on Climate Economics series, internal groups focused on the emerging climate literature, and academic conferences at several Federal Reserve Banks.37 Federal Reserve staff are collaborating and sharing knowledge through our System Climate Network and other forums. We have recruited economists with expertise in climate-related topics and obtained a variety of climate-related data resources.
Last month, the Federal Reserve Financial Stability Report incorporated for the first time an analysis of the ways climate change could present risks to financial stability.38 Similarly, the Federal Reserve Supervision and Regulation Report described how climate-related risks can create microprudential risks and how supervisors are working to better understand, measure, and mitigate these risks.39 Last quarter, the Federal Reserve released a CRA proposal that for the first time highlighted the importance of investing in climate resilience for LMI and underserved communities.
Building on this foundation, this week the Federal Reserve Board became a full member of the NGFS. We look forward to learning from and collaborating with foreign central banks on addressing data gaps and undertaking research on the implications of climate change for financial stability and the economy.40
In the years ahead, there will be significant opportunities for collaboration across the U.S. regulatory agencies in strengthening the U.S. financial system to meet the challenge of climate change. Together, these efforts can help equip the deepest financial market in the world to support our dynamic private sector in assessing and addressing climate-related risks and investing in the transition.
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