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The Fed will face a brand new problem: local weather change

Environmentalists from Extinction Rebellion protest at Bank Junction in the financial district on day 7 of their October Rising campaign on October 14, 2019 in London, England.

Ollie Millington | Getty Images

The Federal Reserve is going green, and that could mean a major change in the way financial institutions must prepare for the unexpected.

In the past few days, several central bank officials have spoken about the importance of putting climate change into action, given the threats to the system. The climate was first mentioned in the Fed's Financial Stability Report, which typically outlines how economic and market forces could affect banks, insurance companies and other companies.

While none of the presentations dealt with anything the Fed could specifically do from a regulatory perspective, the emphasis was clearly on how important the topic has become.

"The US Federal Reserve regulators expect banks to have systems that adequately identify, measure, control and monitor all material risks, which are likely to impact climate risks for many banks," said the financial stability report.

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Fed Governor Lael Brainard first raised the need to address the issue a little over a year ago.

In a statement accompanying the report, it stated that "climate change poses a significant risk to financial stability". The report cites price instability that could be caused by climate-induced weather events such as tornadoes and floods, which result in households and businesses being over-indebted relative to assets, leading to panic selling.

"It is crucial to move from realizing that climate change is a significant risk to financial stability to a stage where the quantitative impact of those risks is properly assessed and addressed," added Brainard, who is believed to that he is a top contender for Secretary of the Treasury in President-Elect Joe Biden's Cabinet.

Fed chairman Jerome Powell also recently addressed the issue, saying at his press conference after the meeting a week ago that "including climate change in our thinking about financial regulation, as you know, is relatively new. And we are are at the very early stages of this to stay tuned and to work with our central bank colleagues and other colleagues around the world to see how this can be part of our framework. "

The Fed has applied for membership in the Financial System Greening Network, a group of global central banks tasked with studying the effects of climate on finances. Randal Quarles, vice chairman of the Fed, also touched on the subject this week, as did Kevin Stiroh, executive vice president of the New York Fed, who said in a speech that financial companies have taken "important steps" to address the risks of climate change to integrate into their thinking. "This work is still in its infancy."

"A very big statement"

How all of this could affect policy and regulation is unclear, but the move has pleased those working for environmental reform.

"We think this is a very big statement from the Federal Reserve," said Steven Rothstein, executive director of the Ceres Accelerator for Sustainable Capital Markets, a nonprofit that focuses on sustainability issues. "The Fed and other financial regulators need to address this not only because it is important from a climatic perspective, but because it is fundamental to the stability of our financial institutions."

In practice, the Fed and other regulators could urge institutions to disclose and measure climate risk in the same way they do now through standard stress tests.

Rothstein also said, for example, that bank auditors should be trained to ask about climate risk. Banks and insurance companies should be aware of the various geographic risks they face, such as 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 US, the focus on the climate is even more topical, Rothstein said.

"There are broader issues like the return to Paris and the major infrastructure package that may appear early next year," said Rothstein. "Until recently, US financial regulators were not seen as real climate leaders. This is different from the rest of the world."

Much to take over

The foray into the climate comes at a time when the Fed is already having its hands full.

In response to the coronavirus pandemic, officials this year launched the most aggressive package of monetary programs the institution has ever seen. In addition, the Fed recently announced a political lynchpin for inflation that is likely to keep interest rates near zero for years.

"When you talk about the impact of climate change on lending, I think the Fed is safe there. What they don't want to do is go beyond their boundaries, which are either monetary or banking supervision, and get into the political Aspect of that, "said Christopher Whalen, former investment banker and head of Whalen Global Advisors. "I don't think the Fed should be sidetracked. There are many other important things to worry about."

Indeed, the extent to which the problem could affect a wide range of sectors and interested government agencies is potentially enormous.

"One of the key priorities, some of which of course includes multiple agencies and the executive and central bank authorities, is the disclosure, measurement, modeling and mitigation of climate risk in the financial system," said Krishna Guha, director of global policy and central bank strategy for Evercore ISI in a note.

With a pro-green Biden government on the way and ongoing pressure on the Fed, climate change is likely to become a significant task in the years to come.

"We give the Federal Reserve great credit for its progress, leadership, and understanding that the climate poses systemic financial risk," said Rothstein. "Without them, we could have dramatic losses far greater than what our country saw in the 2008 and 2009 sub-prime housing collapse. We hope that each of the financial regulators will follow the example that the Federal Reserve has just shown when they do declared that the climate is a climate. " Financial risk."

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