Co-Authored
George Gallagher, ESG, Climate Risk, Natural Hazard and Spatial Solutions, CoreLogic
David L. Risdon, Executive Vice President, Specialty Practice Leader, Bank Credit Risk Solutions, Newmark Valuation & Advisory
George Gallagher, Kent David, Scott Giberson and Anand Srinivasan of CoreLogic sat down with David L. Risdon and Joe Posavec of Newmark Valuation & Advisory (V&A) to discuss increased scrutiny in the banking environment, climate risk as the next big challenge for banks and regulators, and lessons learned about regulations and reporting from Comprehensive Capital Analysis and Review (CCAR) stress testing.
In light of recent bank failures, regulatory scrutiny of banks is intensifying. With this increased attention, regulators are examining the challenges facing banks, and climate-related financial risks rank at the top of the list of concerns. Regulators are asking banks, “Are you prepared?”
To examine the resiliency of six of the largest U.S. banks in the face of climate perils, the Federal Reserve Board (FRB) is currently performing a pilot Climate Scenario Analysis (CSA) exercise. The study considers a range of possible future climate pathways and the associated economic and financial effects on banks. Reporting is due by July 31, 2023, with results and guidelines expected later this year. Although the findings from this pilot will undoubtedly help fashion an understanding of climate-related risk for banks, it will likely only be the beginning of a more comprehensive development of climate scenario studies and reporting requirements.
CCAR Stress Testing and Lessons Learned
After the Dodd-Frank Act was passed in 2010, the FRB developed CCAR stress tests to help define weaknesses and strengthen banks against future credit risk. In discussions between Newmark V&A and CoreLogic®, both teams agreed that the pilot CSA exercise would reveal the need for similar climate-scenario stress testing requirements to be established for banks and wondered what banks could learn from past testing.
Since its inception, CCAR testing has not only helped improve how credit information is gathered, but it has also highlighted some weaknesses in how banks managed data, resources and risk. Identified weaknesses included:
- Modeled/peer data is not detailed enough to evaluate risk accurately.
- A shared terminology and common framework, such as a standardized risk score, are needed.
- Challenges in gathering appropriate technologies, knowledgeable personnel and digitized portfolios that are necessary for banks to analyze and report risks.
While the insights gleaned from CCAR stress testing are valuable, completing such an analysis takes time. From establishing guidance to ensuring compliance, the FRB’s CCAR tests took two years to complete. Compared to European banking institutions, where climate risk reporting is already required, this extended timeline has made the U.S. slow to adopt the necessary changes that promote resilience. Now though, it is time to strengthen the U.S. financial system against future climate perils.
In response to the FRB’s CSA exercise, the Office of the Comptroller of the Currency and the Federal Reserve are expected to introduce guidance later this year. The teams of experts from CoreLogic and Newmark V&A looked back at the initial CCAR stress testing requirements to make an educated guess about what will be required in the future — a timeframe for compliance, scenario analysis and detailed reporting — and how banks can begin to prepare.
Start by Leveraging What Is Known
CoreLogic experts suggest the banking industry should begin by building processes that are familiar. Banks already accustomed to CCAR and other forms of stress testing will find that leaning on existing processes is the most efficient way of incorporating climate risk analytics into their businesses. Of course, credit risk differs from climate risk, which the panel identifies as a challenge for banks. Banks will need to efficiently leverage learnings from early CCAR testing and understand how government expectations from CCAR stress tests could be applied to climate risk.
Newmark’s David Risdon summed it up well.
“One thing we learned from CCAR, and other stress testing, is that when it comes to analyzing a portfolio, details matter. In this era of regulation and the need for efficient compliance, banks discovered that modeling, assuming and aggregating was not the right approach. Banks received pushback from regulators for using poor data, which cost time, money, personnel and resources. When it comes to the CSA exercise, regulators will want banks to be looking at loan-level details. In terms of climate risk, a loan-by-loan analysis is crucial,” he said.
To facilitate climate change reporting in the future, banks will need to incorporate best practices, such as capturing loan data at a property level and aligning it with digital records, today. Banks currently capture the size of the property but do not capture property data such as elevation, building materials, structure, surrounding brush/trees, etc., which is necessary information to accurately determine a property’s climate risk. Regulators will want reporting on data relevant to climate risk, not just property-level physical insights and financials but also specific peril impacts and climate scenarios.
Extra Challenges for Commercial Portfolios
Banks may find challenges in aggregating specific property climate and peril insights, especially when it comes to commercial portfolios. Residential loan portfolios are straightforward — individual properties and street addresses can easily be mapped to any system for analysis. However, when it comes to commercial loans, portfolio analysis is more complicated.
Most banks in a servicing platform only capture digital data on one address — the primary or largest asset in the collateral pool — and they may not have knowledge or documentation on the rest of the collateral without examining files in detail.
Risdon emphasized that fact saying, “The Fed will be looking to run scenarios against collateral on a given loan and perhaps that collateral is 30 different properties spread out across California. When banks realize that they don’t have that information readily available digitally, it could be a surprise.”
Where Does Insurance Fit into the Conversation?
Banks need to understand the mitigating effects of insurance on climate-related losses. Kent David of CoreLogic highlighted three important questions that banks should ask themselves:
- Is there adequate coverage for the collateral, and do banks know exactly what that coverage is and what coverage is needed?
- Following the serious impacts resulting from California wildfires, insurance companies should ask themselves if they are at risk from a climate change event due to being over-extended.
- Are there uncovered perils on a location-by-location basis for a given type of commercial entity? Each property may have a different exposure, and commercial entities may have properties across a broad area. Typically, a commercial policy will not involve just one insurer but will have different layers from multiple insurers.
To accurately assess all possible climate risks to collateral, whether for regulators or for insurance purposes, banks need digitized data on every property in their portfolios as well as the ability to model climate perils into the future.
CoreLogic Climate Risk Analytics: A Window into the Future
What can banks do if they don’t have digital access to detailed information on their collateral? How do they begin to fully assess their collateral insurance needs? What if they don’t have the resources to create peril models? Where do they begin?
They begin by understanding their risk exposure.
CoreLogic Climate Risk Analytics offers a comprehensive view of physical risk that combines hyper-local property data with financial information to estimate and mitigate the impact and cost of future catastrophes. This solution — built on Google Cloud’s secure and sustainable infrastructure — is designed to help companies, government agencies and enterprises measure, model and mitigate the physical risks of climate change to the housing industry from the present through 2050. This approach can help banks quantitatively articulate their overall physical risks while fulfilling their regulatory obligations to federal agencies.
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