The Fed: Measuring, Managing and Mitigating Climate-Related Financial Risks

George Gallagher
July 18, 2023

Software is the key to unlocking future property risk insights

Authored: George Gallagher, ESG, Climate Risk, Natural Hazard and Spatial Solutions
A lot of “firsts” have come about as The Federal Reserve’s Pilot Climate Scenario Analysis Exercise works to put measurements and metrics in place to understand the financial community’s exposure to climate change. This is the first time in the U.S. that climate-scenario analysis and market-recognized metrics have been combined. It is also the first time that banks are being asked to report on climate risk exposure in such a way. Banks have long had portfolios of property data but have not systematically aggregated them to assess future climate risk questions. CoreLogic® is using climate risk software to help businesses and regulators understand their exposure, as well as address questions about risk factors and how to measure impacts against a property portfolio.

What Are the Banks Doing to Evaluate Climate Risk Scores?

In October 2022, the Fed announced a pilot exercise with Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley and Wells Fargo to closely examine their portfolios (as of Dec. 31, 2022) and to report on two types of risks. The first is the transition risks associated with the commercial, government and consumer responses to climate change within their commercial and real estate lending portfolios. The second is the physical risks posed to these portfolios. The physical risk analysis examines two potential perils based on the year 2050: The impact of a severe hurricane in the Northeastern United States The impact of a severe natural disaster in a geographical location of the banks’ choosing The banks then project losses for each of these scenarios: A 100-year return loss event (with a 1% probability of the peril occurring) A 200-year return loss event, with insurance (with a 0.5% probability of the peril occurring) A 200-year return loss event without insurance (with a 0.5% probability of the peril occurring) The probabilities of these events occurring are small but potentially devastating. The analysis of property risk in the face of climate change will cover a one-year period and include projected climate changes such as extreme heat, heavy precipitation and drought. The banks will submit their findings by July 31, 2023.

Why Is the Fed Assessing Property Risk Now?

The Fed seeks to build a more secure and resilient financial foundation and is aware that climate risk is a serious, impending challenge. Recent banking disruptions have increased the need for understanding the risks that climate change poses to banks’ portfolios. In the case of the credit and financial reporting that raised red flags with Silicon Valley Bank, there was a system in place to identify those flags, even if they were waving long before being noticed. In the physical hazard space , this type of federal reporting does not exist, meaning that no guidelines indicate what needs reporting or even what a red flag would look like. Hoping to use this exercise to begin developing an early warning reporting system for climate, the Fed is looking to define meaningful and measurable metrics to track lenders and their portfolios. The Fed can then share and articulate these metrics so that investors can understand what is happening in real time. The Fed is pushing for this testing now because the U.S. is playing catch up. Most of the global economy has already begun measuring and reporting on the impacts of climate change, and the U.S. must be aware the future ahead and reporting methods, particularly to property owners.

It Is Not Just What Banks Report but How They Report It

By calling this pilot a “learning exercise,” the Fed’s intent is to learn if the banks have the resources, the processes and the knowledge base to complete these reports for two separate perils, under three different scenarios and in two different geographic areas. When the Fed reports on these outcomes later this year, findings will be anonymized, providing industry-wide results on climate risk scores. This will be a benchmark in the marketplace when we learn what information the banks can report and discover how to leverage that data.

Assessing the Climate Risk Pilot Exercise and the Need for Regulations

There is a desire for some regulation among banks. With regulation, the banks that are already examining climate risks can show their work and demonstrate how they have been proactive in getting out on the front edge of resiliency, climate awareness and climate education. As a result of exercises like this, we will most likely see the broad definition of climate change start to change. Hopefully, after the Fed evaluates the results of this exercise, requirements will hopefully be more clearly and narrowly defined. And that is a good thing in the marketplace. Regulations can be challenging for banks, but these same rules can help them to understand their risks, prepare for disasters and create a shared terminology for reporting.

How Can CoreLogic Help Banks Analyze Their Risks?

Addressing climate risk requires climate risk software to achieve three distinct steps: Accurate measurement Probabilistic modeling Potential mitigation actions CoreLogic’s Climate Risk Analytics software helps banks perform the first two steps to clarify what needs to be done in the third. Climate Risk Analytics looks at credit and climate risks together, incorporating the portfolio of use. The solution models properties that may be impacted by the range of events that may occur, as well as identifying the particulars of each location in terms of building structure, the level of insurance and the loan-to-value ratio. To answer the question of a bank’s climate risk comprehensively, portfolios need to be examined on a loan-by-loan basis at this granular level. Climate change includes all perils that could impact the valuation and utility of a property. Our proprietary climate models articulate exactly what a peril will look like, projecting to the year 2050, so you can protect your property, prepare accurate climate compliance and lessen the impact on your bottom line. For more information, please visit Climate Risk Analytics.
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