Insight

Climate scenario analysis

Stress testing is distinct from scenario analysis

Amy S. Matsuo

Amy S. Matsuo

Regulatory and ESG Insights Leader, KPMG US

+1 919-664-7100

In testimony before the Senate Banking Committee, Federal Reserve Board Chairman Powell confirmed that climate stress scenarios will be an “important priority” and a ”key tool” for the agency going forward. In addition, he drew a distinction between stress testing, which examines capital adequacy, and scenario analysis, which he described as a risk management tool to help financial institutions understand the risks in their business models posed by climate change over time.

U.S. regulators have been encouraging the development and adoption of climate scenario analysis, consistent with Chair Powell’s explanation, for some time:

  • FSOC. In a report on climate-related financial risk, the members of the Financial Stability Oversight Council (FSOC) recommended the use of scenario analysis as a tool for assessing climate-related financial risks, taking into account their supervisory and regulatory mandates and the size, complexity, and activities of regulated entities. The report defines climate scenario analysis as “a forward-looking projection of risk outcomes that provides a structured approach for considering potential future risks associated with climate change.”
  • FRB. Federal Reserve Board Governor Brainard helped to set expectations regarding efforts to build, iterate, and enhance climate risk modelling by outlining the FRB’s efforts to develop scenario analysis to model the possible risks associated with climate change for both individual institutions and the entire financial system. She stated, “Scenario analysis is a useful tool in assessing the links between climate-related risks and economic outcomes because it requires assessing the implications for financial stability and individual financial institutions in a systematic way.”
  • OCC. Scenario analysis is one of the proposed principles for climate-related financial risk management recently released by the Office of the Comptroller of the Currency (OCC). The guidance states that scenario analysis exercises “differ from traditional stress testing exercises that typically assess the potential impacts of transitory shocks to near-term economic and financial conditions.” Acting Comptroller of the Currency Hsu separately stated that “Boards should push senior management hard to develop scenario analyses, both top down and bottom up, as doing scenario analysis well takes time.”

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