# Demystifying US Fed’s approach on Systemic Climate Risk Stress Testing
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2021-11-29
Category: BANKING
Category URL: https://financedigest.com/category/banking
Meta Title: Fed's Climate Risk Stress Testing Procedure
Meta Description: Discover how the Federal Reserve's CRISK-based stress testing procedure assesses the resilience of financial institutions to climate-related risks.
URL: https://financedigest.com/demystifying-us-feds-approach-on-systemic-climate-risk-stress-testinghtml

![undefined](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/green-eco-globe-sbi-300079739-1736836804907-compressed.jpg)

**1\. Overview of Fed’s Approach for Climate Risk Stress Testing**

The Federal Reserve (EBA) published a in September detailing out stress testing procedure to test resilience of financial institutions to climate-related risks. Fed has introduced a measure called CRISK (systemic climate risk) to measure expected capital shortfall of financial institution in a climate stress scenario. Fed has used this procedure to study the climate [risks of large global banks in US, UK , Canada, Japan, and France in the collapse of fossil fuel prices during 2020 and noted that there is substantial increase in climate systemic risks during 2020 when energy](https://www.financedigest.com/britains-tax-take-risks-blowing-green-energy-off-target.html "Britain’s tax take risks blowing green energy off target") prices collapsed.

Though this research is based on multiple climate research work undertaken by US Fed last year and currently only considers transition climate risks, proposed approach can also be extended to incorporate physical climate risks.

Objective of this paper is to look at the Fed proposed stress testing approach in-detail against climate risk objectives of central banks, including practical challenges in proposed methodology, how other central banks can adopt the proposed approach, and what can individual [financial institutions learn from such systemic climate stress testing approach](https://www.financedigest.com/4-key-financial-trends-as-we-approach-2021.html "4 Key Financial Trends as we Approach 2021").

**2\. Climate Risk [Stress Testing](https://www.financedigest.com/what-to-make-of-the-headlines-brexit-and-bank-of-england-policy-eba-bank-stress-tests.html "What to make of the headlines? Brexit and Bank of England policy, EBA bank stress tests") Methodology**

As guided by NGFS in their report to central banks “ _climate-related_ _risks_ _are a source of financial risk_. It is therefore within the mandates of central banks and supervisors to ensure the [financial system](https://www.financedigest.com/why-a-rules-management-system-can-untie-financial-services-hands.html "Why a rules management system can untie financial services’ hands") is resilient to these risks.”

Climate change is one of many sources of structural change affecting financial system and for central [banks to integrate climate-related risks into financial stability](https://www.financedigest.com/banking-stability-worries-go-behind-closed-doors-at-imf-world-bank-meetings.html "Banking stability worries go behind closed doors at IMF-World Bank meetings") monitoring and micro supervision it is essential to assess climate related financial risks in the financial system. Through proposed stress testing approach, Fed [addresses an important perspective of how much systemic risks climate change](https://www.financedigest.com/exclusive-world-bank-seeks-more-funds-to-address-climate-change-other-crises-document.html "Exclusive-World Bank seeks more funds to address climate change, other crises -document") impose on financial system. It contains three major steps.

1. Measurement of climate risk factor
2. Estimation of climate beta of [financial institution](https://www.financedigest.com/what-the-future-holds-for-financial-institutions-in-2023.html "What the Future Holds For Financial Institutions in 2023")
3. Compute CRISK i.e., [expected equity loss](https://www.financedigest.com/dollar-set-for-weekly-loss-amid-expectations-fed-will-slow-hikes.html "Dollar set for weekly loss amid expectations Fed will slow hikes") conditional on climate stress

Below is the graphical representation of stress testing procedure proposed by Federal Reserve.

![](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/demystifying-us-feds-approach-pic1-1736836804935-compressed.jpg)

Step 1 –  There are several [ways to measure transition climate risk](https://www.financedigest.com/analysis-watch-out-risk-assets-the-rout-in-bonds-is-coming-your-way.html "Analysis-Watch out risk assets, the rout in bonds is coming your way") factors from policy & legal, technology, reputation & market demand perspective. Fed considered ‘portfolio return of stranded assets’ as a key risk factor in assessing transition [climate risk of various assets held by institution’s](https://www.financedigest.com/institutional-investors-back-shell-board-lawsuit-over-climate-risk.html "Institutional investors back Shell board lawsuit over climate risk") books.

Step 2 – Climate beta is calculated to measure the sensitivity of [bank to market risk](https://www.financedigest.com/risk-of-uk-balance-of-payments-crisis-under-truss-is-rising-deutsche-bank-warns.html "Risk of UK balance of payments crisis under Truss is rising, Deutsche Bank warns") and transition related climate risks.  [bank with high exposure to fossil fuel industries and related infrastructure will have positive climate beta compared to others, and where a bank holds a large amount of loans in the renewable](https://www.financedigest.com/first-abu-dhabi-bank-could-renew-35-billion-offer-for-stanchart-bloomberg-news.html "First Abu Dhabi Bank could renew  billion offer for StanChart -Bloomberg News") energy sector, the bank’s climate beta could be negative

Step 3 – CRISK is the expected shortfall of a [financial institution](https://www.financedigest.com/a-cloud-migration-guide-for-financial-institutions.html "A Cloud Migration Guide for Financial Institutions") in a climate stress scenario. It means positive CRISK indicates institution has capital deficit and negative CRISK indicates institution has capital surplus.

- **Practical Challenges & Key Considerations**

While it appears to be a simplistic exercise to conduct proposed CRISK based stress testing procedure there are number of practical [challenges to be addressed by central banks](https://www.financedigest.com/big-banks-can-be-challengers-too.html "Big banks can be challengers too") in various touch points throughout the value chain. Challenges include data sourcing & quality, risk factor measurement and calibration, dynamic climate beta calculation, aggregation of CRISK measures & extracting relevant insights. In the below section we discuss about what are those relevant key considerations.

![](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/demystifying-us-feds-approach-pic2-1736836804998-compressed.jpg)

- **What does it mean to other [Central Banks](https://www.financedigest.com/testing-waters-hungarys-central-bank-flags-cut-in-top-end-of-rate-corridor.html "Testing waters, Hungary’s central bank flags cut in top end of rate corridor") & Our Recommendations.**

Fed’s stress testing exercise considered exposures of various US banks to oil and gas industry and observed climate related [impact on the financial system](https://www.financedigest.com/impact-of-new-cheque-clearing-system-discussed-at-leading-seminar.html "Impact of New Cheque Clearing System Discussed at Leading Seminar "). Proposed approach can very well be followed  by central banks from other jurisdictions, for number of other sectors to analyze [impact of sector specific climate](https://www.financedigest.com/climate-impacts-heading-to-uncharted-territories-of-destruction-un-chief.html "Climate impacts heading to ‘uncharted territories of destruction’ -UN chief") shocks on overall economy.

Although climate risk factors causing asset stranding are many, it could vary for each sector and few channels will be more relevant for a sector than others. We suggest institutions to capture underlying sector specific assumptions and rationale for any specific sensitivity assumptions. Below are the sample channels through which asset stranding could occur.

- Environmental challenges (e.g., [climate change](https://www.financedigest.com/deloitte-research-reveals-inaction-on-climate-change-could-cost-the-worlds-economy-us178-trillion-by-2070.html "Deloitte research reveals inaction on climate change could cost the world’s economy US8 trillion by 2070"), natural capital degradation)
- Changing resource landscapes (e.g., shale gas abundance, phosphate scarcity)
- New government regulations (e.g., carbon pricing, air pollution regulation)
- Falling clean technology costs (e.g., solar photovoltaic, onshore wind, electric vehicles)
- Evolving social norms (e.g., [fossil fuel](https://www.financedigest.com/eu-approves-effective-ban-on-new-fossil-fuel-cars-from-2035.html "EU approves effective ban on new fossil fuel cars from 2035") divestment campaign) and consumer behavior (e.g., certification schemes)
- Litigation (e.g., carbon liability) and changing statutory interpretations (e.g., fiduciary duty, disclosure requirements).

_Source :  Stranded Assets – A climate [risk challenge](https://www.financedigest.com/5-challenges-to-overcome-in-governance-risk-and-compliance-magazine.html "5 Challenges to Overcome in Governance, Risk and Compliance-Magazine") ( Inter-American Development Bank )_

We recommend other central banks follow three-pronged streamlined approach in carrying out system wide stress testing process effectively while  carefully [ensuring](https://www.financedigest.com/ensuring-traders-pass-the-test-of-mifid-ii-and-mar.html "Ensuring traders pass the test of MiFID II and MAR") that above considerations are assessed throughout various touch points of stress testing approach. Largely these framework components overlap with traditional economic stress testing and could be leveraged for climate stress testing as well.

![](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/demystifying-us-feds-approach-pic3-1736836805008-compressed.jpg)

- **Conclusion & Next Steps Way Forward**

It is indeed a meticulous exercise to undertake financial system wide climate risk stress testing with comparable set of data-driven scenarios encompassing a range of different plausible future states of the world, US [Fed has taken simplistic but scalable approach](https://www.financedigest.com/oil-falls-on-demand-worry-as-fed-make-or-break-moment-approaches.html "Oil falls on demand worry as Fed ‘make or break moment’ approaches") that can be widely leveraged by other supervisors across jurisdictions.

While we recognize that various measures taken by global [central banks & supervisors to assess climate](https://www.financedigest.com/inflation-fighting-central-bankers-air-climate-role-doubts.html "Inflation fighting central bankers air climate role doubts") related risks to financial system are at nascent stage, it is essential that supervisors in other jurisdictions  perform similar exercise and share best practices and industry learnings. Not only from sharing relevant climate [risk data](https://www.financedigest.com/tesla-to-warn-of-data-privacy-risk-from-car-security-cameras-in-germany.html "Tesla to warn of data privacy risk from car security cameras in Germany") sets, but central banks could also collaborate through uniformed methodologies and consistent aggregation of stress testing outputs to enable appropriate comparison of outputs.

**_Author’s Bio_**

_Sudalaimuthu Gurusamy is a Domain Consultant with the [Risk Management practice of the Banking](https://www.financedigest.com/strategies-banks-use-to-manage-liquidity-risk.html "Strategies Banks Use to Manage Liquidity Risk") and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). During his 13 years of experience in consulting, he has worked on several global [risk and compliance engagements as Risk Domain Consultant/Senior Business](https://www.financedigest.com/aon-assists-freddie-mac-to-reach-5bn-risk-transfer-milestone-for-u-s-mortgage-credit-business.html "AON ASSISTS FREDDIE MAC TO REACH BN RISK TRANSFER MILESTONE FOR U.S. MORTGAGE CREDIT BUSINESS") Analyst._

_A GARP certified [Financial Risk Manager™ and Sustainability & Climate](https://www.financedigest.com/financial-risks-of-climate-change-overplayed-senior-hsbc-banker-says.html "Financial risks of climate change overplayed, senior HSBC banker says") Risk™ professional, Sudalaimuthu holds a master’s degree in Business Administration from the Anna University, Chennai, India. His [risk consulting experience revolves around Credit risk Transformation, Risk Data Transformation Initiatives, BCBS 239, BASEL II, BASEL III, Liquidity risk management](https://www.financedigest.com/managing-corporate-currency-risk-the-cfos-balancing-act.html "Managing Corporate Currency Risk: The CFO’s Balancing Act"), Loan loss forecasting and provisioning, and risk regulatory reporting. Recently he is working on developing risk solutions to cater to emerging [risks domains including operational](https://www.financedigest.com/mitigating-operational-risk-through-centralising-reconciliation.html "MITIGATING OPERATIONAL RISK THROUGH CENTRALISING RECONCILIATION") resiliency & climate ris_


---
This blog is powered by Superblog. Visit https://superblog.ai to know more.
---