The Federal Reserve is going green, and that could mean a substantial change for the way financial institutions have to prepare for the unexpected.
In recent days, several central bank officials have spoken about the importance of taking climate change into effect when considering dangers posed to the system. Along with that, the Fed’s financial stability report, which usually talks about how economic and market forces could impact banks, insurance companies and other firms, mentioned climate for the first time.
While none of the talk addressed anything the Fed might do specifically from a regulatory standpoint, the emphasis was clear on how important the issue has become.
“Federal Reserve supervisors expect banks to have systems in place that appropriately identify, measure, control, and monitor all of their material risks, which for many banks are likely to extend to climate risks,” the financial stability report said.
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Fed Governor Lael Brainard first brought up the need to address the issue just over a year ago.
In a statement accompanying the report, she noted that “climate change poses important risks to financial stability.” The report cites price instability that could come from climate-driven weather events like tornadoes and floods that cause households and businesses to have too much debt relative to assets, forcing panic selling.
“It is vitally important to move from the recognition that climate change poses significant financial stability risks to the stage where the quantitative implications of those risks are appropriately assessed and addressed,” added Brainard, who is believed to be a top contender for Treasury secretary in President-elect Joe Biden’s Cabinet.
Fed Chairman Jerome Powell also addressed the issue recently, noting at his post-meeting news conference a week ago that “incorporating climate change into our thinking about financial regulation is relatively new, as you know. And we are very actively in the early stages of this, getting up to speed, working with our central bank colleagues and other colleagues around the world to try to think about how this can be part of our framework.”
The Fed has requested membership in the Network for Greening the Financial System, a group of global central banks aimed at addressing the impact climate has on finance. Fed Vice Chairman Randal Quarles also addressed the issue this week, as did Kevin Stiroh, executive vice president at the New York Fed, who said in a speech that financial firms have “taken important steps” toward integrating climate change risks into their thinking though “this work is still in its early days.”
How it all might impact policy and regulation at this point is unclear, but the move has pleased those who advocate for environmental reform.
“We think this is a very big statement from the Federal Reserve,” said Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets, a nonprofit focused on sustainability issues. “The Fed and other financial regulators need to address this not just because it’s important from a climate perspective, but because it is fundamental to the stability of our financial institutions.”
As a practical matter, the Fed and other regulators could push institutions to disclose and measure climate risk in much the same way they do now through standard stress testing.
Rothstein also said, for instance, that bank examiners should be trained to ask about climate risk. Banks and insurance companies should be aware of the various geographical risks they face, such as from floods or earthquakes, and prepare accordingly, he added.
With Biden’s focus on environmental issues, such as the Paris Agreement talks from which President Donald Trump withdrew the U.S., the focus on climate is even timelier, Rothstein said.
“There are broader issues like returning to Paris and the significant infrastructure package that may occur early next year,” Rothstein said. “Until recently, the financial regulators in the United States haven’t been seen as real leaders in climate. That is different than what’s happening around the world.”
The foray into climate comes at a time when the Fed already has its hands full.
In response to the coronavirus pandemic, officials this year rolled out and are administering the most aggressive package of monetary programs the institution has ever seen. In addition, the Fed recently announced a policy pivot on inflation that likely will keep interest rates anchored near zero for years.
“If you’re talking about the impact of credit on climate change, I think the Fed is safe there. What they don’t want to do is go outside their boundaries, which is either monetary or bank supervision, and start to get into the policy aspect of this,” said Christopher Whalen, a former investment banker and head of Whalen Global Advisors. “I don’t think the Fed should let this distract them. They have many more important things to worry about.”
Indeed, the extent to which the issue could cut against a broad swath of sectors and interested government entities is potentially enormous.
“Core areas of focus — some of which of course span multiple agencies and the executive branch as well as central bank authorities — include a focus on disclosure, measurement, modeling and mitigation of climate risk in the financial system,” Krishna Guha, head of global policy and central bank strategy for Evercore ISI, said in a note.
Still, with a pro-green Biden administration on the way and continued pressure on the Fed, climate change likely will emerge as a significant job in the years ahead.
“We give the Federal Reserve great credit for moving forward, for their leadership and understanding that climate is a systemic financial risk,” Rothstein said. “Without it, we could have dramatic losses much greater than what our country saw in the 2008 and 2009 subprime housing collapse. We hope that every one of the financial regulators follows the lead that the Federal Reserve has just shown in declaring that climate is a financial risk.”