“Stress Testing” Banks for Climate Fitness

February 23, 2021

As Texas showed us last week, climate change impacts can sneak up on us because the underlying signal is (in human terms) very gradual, but jumps out when extreme events stress engineering or economic systems beyond the design assumptions – it’s an emerging pattern.

In reviewing my 2014 interview with Richard Alley, I found he spoke exactly to this point, in terms of both built and economic infrastructure.

ClimateWire:

Treasury Secretary Janet Yellen yesterday offered a glimpse of the Biden administration’s approach to mitigating the risks that climate change poses to the financial system.

Progressives were discouraged by what she had to say.

During a virtual event hosted by The New York Times, Yellen said the Treasury Department may facilitate “stress tests” to gauge banks’ and insurers’ ability to stay afloat amid economic volatility spurred by rising temperatures.

But she stopped short of saying climate-related stress tests would come with any tangible consequences for banks or insurers that are identified as overexposed to mounting climate threats. Those threats, she said, could stem from future environmental regulations — such as carbon prices — or the financial fallout of extreme weather.

That marks a significant departure from the stress tests the Federal Reserve currently conducts.

First used widely after the 2007-08 financial crisis, the Fed simulates hypothetical, yet plausible, economic shocks to test banks’ ability to continue lending amid an economic downturn. When firms fail those assessments, they are required to correct the problem — and avoid potential collapse down the line — by socking away more money, among other actions.

But Yellen said this week that when it comes to climate-related stress testing, “it’s not envisioned that these tests would have the same status in terms of limiting payouts and capital requirements.”

Even so, Yellen said, they would be “very revealing both to regulators and to the firms themselves in terms of managing their own risks.”

That line of thinking runs contrary to policy proposals touted by advocates promoting private and public financial sector actors to stem the flow of capital into planet-warming sectors.

They argue that regulators including the Federal Reserve, which Yellen said would ultimately spearhead the tests, have a responsibility to protect the planet from financial firms — not just shield the financial system from climate risks.

Sustainable-finance proponents generally recognize it would be difficult to immediately connect climate stress tests to banks’ capital requirements.

Gregg Gelzinis, of the liberal Center for American Progress, previously told E&E News that’s the case because it involves “projecting out significantly into the future” and because banks’ current balance sheets in the near term will differ greatly from their balance sheets decades down the line (Climatewire, Dec. 4, 2020).

But longer term, Gelzinis is among those who warn against regulators implementing stress tests that would be “completely toothless exercises.”

Former Wall Street analyst Alexis Goldstein, who is currently with Americans for Financial Reform, agreed. “Not pushing to include capital changes or dividend prohibitions as consequences of a stress test takes the ‘stress’ out of the test,” she said.

Others, including the banking industry itself, appear to be with Yellen.

“Trying to capture climate change effects decades in advance — without considering the extraordinary adaptability of the financial system and economy — and incorporating those results into the regulatory capital framework is no easier than predicting how pandemics or machine learning will affect banks by 2050,” the lobbying group Bank Policy Institute wrote in an October 2020 research note.

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