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New York Federal Reserve links greater climate risk facing banks to oil, gas sector

05 October 2021 Amena Saiyid

The Federal Reserve Bank of New York (NY Federal Reserve) for the first time has linked the indirect risks that climate change poses to the banking sector.

The staff of the regional reserve bank examined the impact on banks with loans to the oil and gas sector by using a stress test approach that was developed in response to the 2008 global subprime mortgage crisis.

In a recently released report, Hyeyoon Jung, Robert Engle, and Richard Berner of the NY Federal Reserve found that the exposure for some of these banks arising from indirect climate risk to be "economically substantial."

"This report shows that this risk is so concentrated in the equity of the world's largest banks that it could threaten their ability to retain prudential capital reserves, and in turn limit their ability to withstand financial shocks that could threaten global financial stability as a whole," IHS Markit CleanTech and Climate Executive Director Peter Gardett told Net-Zero Business Daily.

The staff reached this conclusion after measuring climate risk in 27 large global banks in the UK, US, Canada, Japan, and France that together hold more than 80% of the syndicated loans made to the oil and gas industry.

No course of action recommended

Their report, however, stopped short of recommending any course of action for the US Federal Reserve Board, which plans to include climate change risk as part of its framework to assess the financial stability of banks that it oversees, and is in the throes of completing a study.

The report also didn't evaluate the direct physical climate risk to banks, but said the same approach could be applied.

The inclusion of climate risk into the central bank's assessments will take place after the Fed completes its study of the vulnerabilities that financial institutions potentially face "both from the consequences of climate change and the policies designed to mitigate that effect."

The report's findings are significant because they give an indication of a climate-stress test approach the NY Federal Reserve is taking seriously enough to release it publicly, Gardett said.

Increased exposure

Banks that provide financing to firms that extract or use fossil fuels are expected to see an increase in their exposure when the default risk of their loan portfolios rises as economies transition to a lower-carbon environment, according to the paper.

There is no question that "climate change poses a considerable risk to the financial system," if banks systemically suffer substantial losses following an abrupt rise in the physical risks posed by climate-fueled hurricanes or wildfires that result in destruction of homes and businesses, or transition risks, it added.

The NY Federal Reserve report authors set out to discover how resilient financial systems were to climate-related risk by measuring "CRISK," the expected impact on a bank's capital during a climate stress scenario. The authors measured it by making a climate-based update to a systemic risk calculation, or "SRISK," that a group of economists developed a decade earlier to measure the resiliency of banks after the global financial crisis.

According to Gardett, they examined the impact of the fossil fuel asset repricing exposure as a result of climate impacts across each bank's debt position, across the change in climate risk position in order to account for the long-run marginal expected shortfall in repayments, and across each bank's equity expressed as its market capitalization.

Decline in market capitalization

The report's calculations show it is the decline in market capitalization that "most swiftly and damagingly" boosts climate risk, putting the bank's prudential capital ratio position at risk, Gardett said.

Prudential ratios are used by banks and their regulators to monitor and determine the stability of banks' finances. These include free capital, capital adequacy, and liquidation ratios, which determine a debtor's ability to pay off current debt obligations without raising external capital.

While the paper measured CRISK between 2000 and 2020 for the 27 large banks, it honed in on 2020 when oil and gas prices essentially collapsed.

That's when the paper was able to align most closely the increase in CRISK at banks with a decrease in equity.

For instance, the paper said Citigroup's CRISK grew by $73 billion in 2020, meaning that is the amount that the bank would have to raise in equity to restore its prudential ratio.

The paper also noted that climate risk readings for banks started to climb in 2018 before rocketing higher in the early months of 2020 and settling at more elevated levels.

US, French, Japanese banks most exposed

Banks in the US, France, and Japan saw the biggest rises in CRISK measurement of the correlation between financial portfolio repricing and their own equity during the period from 2018 onwards, while UK and Canadian banks experienced smaller CRISK rises.

The NY Federal Reserve staff report has implications for banks that are moving towards renewable energy as their calculations showed lower exposure. An IHS Markit analysis of the market showed banks and companies issued at least $175 billion in green bonds that were fitted to investments in clean energy technology.

The International Monetary Fund, in its semi-annual Global Financial Stability Report released 4 October, said the transition to a net-zero carbon economy will require "unprecedented change" by companies and governments, as well as additional investment of as much as $20 trillion over the next two decades.

Posted 05 October 2021 by Amena Saiyid, Senior Climate & Energy Research Analyst, IHS Markit

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