How Is The Fed Helping Prepare Banks For Climate Change Risks?

The U.S. Federal Reserve is looking into ways that it can help protect the economy against climate change after billions of dollars worth of damage from severe weather events.

In a speech before the Boston Federal Reserve on Thursday, Fed Governor Lael Brainard explained to attendees why the central bank was starting to take a deeper look at climate risks.

Brainard told the gathering that after years of deadly wildfires and devastating floods, all with the COVID-19 pandemic in the background has made the Fed wary of how “risks emanating from outside the economy” can impact the financial system.

To contend with these threats, Brainard outlined ways that the Fed will be working to reduce big banks’ exposure to the consequences of extreme weather events.

The main way to do this, according to Brainard, was the creation of a scenario analysis model for climate risks based on the financial stress tests that the Fed introduced after the Great Recession.

Brainard noted that today’s stress tests bear little resemblance to the original ones in terms of the metrics they use for risk management, so it could be adapted to climate planning.

The idea of a stress test for climate risks was also something proposed earlier by Fed Chairman Jerome Powell earlier this year. However, he did note that climate change currently was “not something that we directly consider in setting monetary policy.”

If adopted by the Fed, it would bring the central bank further in line with several of its international peers.

In July, the European Central Bank (ECB) announced that it would begin implementing climate stress tests across the Eurozone countries on the continent. Central banks in Canada, the United Kingdom and Japan are also among those now implementing or considering climate stress tests, too.

Brainard outlined how a climate stress test would require analysis from across the financial sector, singling out insurance companies in particular. After extreme weather events, insurance premiums are pushed upward for businesses and property owners, factors that Brainard said should be accounted for in a bank's risk management strategy.

To assist banks in structuring new risk models, Brainard said the Fed would work to acquire more data to help fill existing gaps. She faulted the current voluntary system for climate data as flawed for producing “inconsistent quality” and “incompleteness." To remedy this, Brainard suggested the Fed would look to create clarity through clear definitions and methods for banks to use.

She also took a moment to comment on accounting for the cost of policies, or “transition risks” in her phrasing, that are aimed at combating climate change. These measures, Brainard says, can be managed in an "orderly and steady transition" to a low-carbon economy, but warned a "disorderly scenario could generate sizable economic consequences."

This cautious message resonates at a time when members of Congress are hoping to make dramatic new investments to mitigate the impact of climate change.

Some of these are included in the pair of multitrillion-dollar infrastructure and social spending plans proposed by President Joe Biden’s Democrats, a bone of contention among lawmakers from fossil fuel-dependent states.

A commitment to fighting climate change is also something that Democrats are encouraging Biden to consider strongly in his selection of a chairman for the Federal Reserve. Biden has not signaled yet whether or not he will replace Chairman Powell, but it is reported Brainard is a candidate some Democrats hope he considers for the role.