SIFMA Chief Operating Officer, Joe Seidel, recently sat down with Michael Brauneis, Financial Services Industry Lead and Managing Director, Protiviti, for a one-on-one conversation on climate stress testing for banks. This is an excerpt from their conversation, one in a series of Executive Viewpoints at SIFMA’s 2021 Annual Meeting.

About Executive Viewpoints

Filmed for SIFMA’s 2021 Annual Meeting, Executive Viewpoints is a series of insightful conversations about trends and innovations shaping the future of our capital markets. The capital markets are in the midst of major transformation, arguably one of their most fundamental shifts yet. In this special series, SIFMA president and CEO Kenneth E. Bentsen, Jr. and chief operating officer Joseph Seidel interview a cross-section of experts to understand just some of the dynamics at play in the market’s next evolution.

To view more from the 2021 SIFMA Annual Meeting, please visit www.sifma.org/annual.

A Conversation with Michael Brauneis

Joe Seidel: The US is going to trail the ECB, as well as regulators in the UK and Canada, in conducting climate stress testing for banks. What do you see as the key lessons learned from the work that has been done so far in other markets, and what do you think the US might be ultimately doing differently from those other markets?

Michael Brauneis: We’ve definitely seen a divergence of approaches across the world, but we’re also starting to see some trends converge. In some ways, the US will have an advantage being able to follow that, and incorporate what’s worked well and what hasn’t.

A couple of things I’d say: One, I’ll probably beat a dead horse on this throughout this conversation, and that’s the data assumptions and data availability. In a lot of ways, the most critical element to this field becoming more relevant and effective over time. I also think it’s the biggest challenge we face today.

As much as the US can do to standardize the data requirements, the information that they’re going to pull out of the banks to conduct the analysis, as well as needing to have a really robust process to validate and reconcile, and make sure that what we got in from the banks is apples to apples before the analysis is done, is going to be really critical.

The second point that I’d make is around industry participation. You saw, for example, the exercise that was done in the Netherlands, I think about four years ago now, was really more data pulled from the banks, but not a lot of involvement throughout the exercise. That’s started to change a bit, as the French and now the UK models have been run.

Clearly, this is such a dynamic and uncertain field, where the regulators, the industry is building and figuring this out a bit as we go along. Obviously, individual participants in the industry have run their own exercises.

Having the chance for that input to be provided, and creative ideas coming bottom-up through the stakeholders, is going to be really important to inform the regulators’ understanding.

The final point that I’d make: It’s interesting if you look at the global exercises. We all know, and your members know, that there are really two critical dimensions or aspects of climate scenario analysis.

That’s a physical risk—so the immediate impact that a disaster is going to have on a particular firm—and then transition risk, associated with things like stranded assets, and changing regulatory restrictions around where we can lend and invest, and so forth.

Climate is unique in having a much longer time horizon than many other risks that are subject to scenario planning. At the same time, there’s so much uncertainty of what carbon levels look 30-50 years from now, how the regulators will respond, how the economy will adapt to that.

In spite of that, a lot of the scenarios so far are really focused on those longer time horizons and more on the transition risks, and not the physical risks.

Given both the immediate exposure that is created by things like Hurricane Ida—unprecedented, at least in my lifetime, how much of the country was exposed to that. The fact that I think we have better and more certain data on the immediate physical risks than we do the transition risks.

It would be good to see the next round of scenario exercises that at least balance, and give a little more coverage to the physical and the short-term than some of the other countries have done so far.

Joe Seidel: Traditionally the outcome of a failed stress test has typically been an increased requirement to capital buffers, and certainly have had sort of extreme events at various institutions when they fail the stress test. Do you think that’s a viable solution for climate stress testing? If not, how do you see the results impacting individual banks otherwise?

Michael Brauneis: It’s definitely a unique aspect of the climate scenario analysis process, that for the time being, it will be more of the macroeconomic industry-wide impact.

I think [it’s] more used to inform supervisory policy and how the regulators look at this in the field, than it is that any bank is going to be required to take any specific action coming out of the exercises.

I don’t think the data that is used to conduct the analysis is standardized enough yet, or granular enough yet, or reliable enough yet, to say that these are the conclusions that we’re absolutely certain are relevant to any individual bank, and this is the action that that bank needs to take.

I’d also say, even potentially when we get to that point—we’ll plot the industry on a spectrum, and you’re going to have a slice all the way to the right if these are the very riskiest, or the most exposed banks, is asking those banks to hold more capital actually going to be the right solution or the right remedy to this?

Could it play a role, and certainly in terms of solvency? Absolutely. But there are going to be other tools that the regulators apply to that problem. Is it going to be portfolio divestment, and you ask banks to reduce their exposure to certain sectors?

One of the things that are going to be really interesting is, as this process starts in the US, the insurance industry and the reinsurers play a huge role, particularly on the physical side of risk, of mitigating exposure.

To the extent that actually the solvency of the insurance companies in the exercises, that then get done globally, was a really important part of that model.

In the US, where we know the insurers are generally more state-regulated and not as directly subject to Federal Reserve or SEC jurisdiction, how are we going to see their balance sheets, and their exposure incorporated into the planning exercises?

I definitely think—where regulators identify an individual bank that needs to bring its exposure down, the question of “Can you hedge your insurer or otherwise mitigate that exposure, short of just increasing the capital buffer,” is going to be definitely part of the equation or part of the toolkit.

Joe Seidel: We hear a lot about greenwashing practices these days. Greenwashing is getting an increasing amount of negative attention, both from regulators as well as the press.

Do you see somehow the future of climate stress testing, or climate scenario analysis, being intertwined with the climate disclosure rules?

Michael Brauneis: Absolutely. That’s another data standardization topic. Having clarity and consistency and apples to apples—both how climate-friendly certain products or assets or practices are, as well as then what exposure those products create to the banks that hold them, or the wealth managers that are invested in them, and so forth, is going to be really critical. I think [it] will build confidence in ESG investing, and also give the industry and the regulators more confidence and more certainty regarding what the exposures are.

Things like the forthcoming IFRS standards, that individual companies will be required to disclose, will help in bringing consistency to how banks analyze their exposure to the companies that they lend to, that have provided those disclosures.

The other key question there is granularity in the data, and granularity in the analysis. Are we doing the scenario analysis at the level of the industry as a whole, or different categories of banks, for example?

You can look at banks that lend globally versus nationally versus within a particular region—[they] are all going to have dramatically different exposures based on how threatened those different regions are, obviously, by things like climate change.

As you get more and more granular and start looking at, what is an individual bank’s climate risk posture, is that based on the exposure of the sectors that they lend to generally? So oil and gas, as a NAICS category, for example.

Are we going to need to start getting into not, every oil and gas company, obviously, is created equal? Some are pivoting towards clean energy faster than others.

Do we need to look at our top ten clients at their disclosures and their individual exposure and weigh that differently? Do we just say, 20 percent of our portfolio is energy or oil and gas, and that puts us—all else being equal—in a worse position than a comparable bank that has 5 percent exposure?

Joe Seidel: Will disclosure be ultimately—as it becomes more and more standardized—will that essentially corporate disclosure become the key piece in the data, that will be necessary to increase the integrity of modeling in this area? What type of data do you think is the missing link here?

In corporate disclosures, it seems like you get a slice, depending on what’s disclosed. It seems like certainly in other areas in bank stressing, you get much, much more granular in the data than anything that’s in the typical corporate disclosure.

What do you think they’re looking for, from the bank regulatory point of view, the BCBS point of view, et cetera?

Michael Brauneis: It’s going to come in later, and have different requirements based on the stakeholder. As you said, the SEC public company requirements, the IFRS standards, et cetera, will be the filer and ultimately the client of the bank, and/or the company that our asset management firms are invested in.

That will be the base layer or the starting point, In any accounting subject, you start with an initial standard, and requirements get added over time, more and more detailed and sophisticated, and complex. I think we’ll definitely see that scenario play out here as well.

You’re going to have what the regulators require individual banks to collect from their clients, in order to complete the bank regulatory reporting, or eventually, we’ll see asset management requirements imposed by the SEC, for example. So that will add a second layer.

Finally, we’re seeing certain firms, among the financial institutions, already more advanced than others in doing their own analysis, and treating it basically as part of the underwriting or credit risk review process.

They’ll have a third set of data that I think likely—although this will shrink over time, as the other two become more granular—for the time being, those will be both more customized, institution by institution, but also probably the more you see the more specific data elements that go above and beyond what IFRS or the SEC or the Fed, for example, would require.

Joe Seidel: Many bankers and your clients probably have a sense of whiplash from working on these issues.

First, the Obama administration that was all-in on the Paris accords; the Trump administration, which was all-out; and now back to the Biden administration, which again is sort of an all-in approach related to the industry and climate, as well as other ESG topics.

Does that inconsistent political environment represent a barrier for firms making long-term investments in these areas? This is often not the case in our world, but would a better path be for Congress to legislate in this area, and have something that’s a little more permanent, and something that’s built to last and can help, so you don’t see priorities constantly shifting in the regulatory community?

Michael Brauneis: I think it would be very helpful, and I also think you’re exactly right that it’s very unlikely, at least in the short term.

When you just look at the polarization that we face in DC right now, as well as all the other priorities that Congress is struggling to get to an agreement on, I think this—unfortunately for the industry—is further down the list. And it’s not likely to happen, certainly in this administration, with this Congress right now.

The other thing that I would say, though, is that although there is that back-and-forth every four years, let’s say, in at last the past eight years or so, the trend line to me is clearly and permanently up. This will become certainly a more critical risk factor. It will get more attention. There will be more requirements, et cetera.

You’re going to see some choppiness in the short term, but still, again, long term, permanently moving to the need to do more in this area.

Unlike other regulatory areas, I don’t think what Congress does, or what regulators do, is the only input that’s going to matter.

You look at the role that the index investment management firms—BlackRock is a great example—are playing in pushing ESG objectives.

I think even employee focus. We’re seeing unprecedented turnover right now. We’re seeing employees—more so than ever in history—take a much higher degree of interest in the ESG practices of the companies that they work for.

You saw McKinsey, for example, earlier this week, face employee protests about the work that their firm does for oil and gas companies. That’s a trend that’s not going to change either.

All of those things, again, will continue to put pressure on the system [so] that our clients—the financial institutions—will need to make this a bigger priority. Whether for risk management reasons or their own corporate values and how those will change, [they] need to make this a bigger priority.

Joe Seidel: Looking at some of the firm practices: In the absence of specific regulatory requirements, how proactive have SIFMA members been in conducting their own voluntary climate stress tests? Could publication of a test like that end up being ultimately a competitive advantage, related to climate issues?

Michael Brauneis: I think it definitely will and in a few ways. One, as you’d expect, I definitely haven’t seen that there’s a universal or an emerging standard practice across the industry. You see a combination of many of the largest, many of the most inherently pro-ESG-focused institutions, that have really made that a priority—again, as a corporate value.

Some of the institutes, for example, have footprints that are concentrated in certain geographic regions that are more exposed to immediate physical risk. If I’m a Gulf Coast regional bank, every year is a worse and worse hurricane season, it seems like. This is a much bigger corporate priority, obviously, for them.

In a similar vein, the banks or the investment management firms that have built a business concentrated on certain industry sectors, that are clearly now more climate-exposed than they were when that strategy was set 10 or 30 or 50 years ago—obviously they are being pushed to refocus or revisit that in a more granular way than the banks that are more inherently diversified.

Those will definitely be factors that I think continue to drive some differences over time. The trend is clear: Across the industry, everyone is doing more than they were five years ago, and trying to get richer and more consistent data, trying to make their analyses more granular and more sophisticated.

The other trend that we’re seeing is, where even a couple of years ago it was more, “Let’s start to measure our exposure and get our arms around this.”

You’re now starting to see—driven both by the likelihood of regulation and by the losses that we’ve seen in some of the recent disasters that have occurred—that we’re moving beyond just, “This is a dashboard and we have a better feeling about what our exposure is” to, “We’re actually going to start to use this for decision-making, and actually make the call.

“Either to reprice and require a higher rate of return for some of these asset categories or maybe we just reduce our exposure and get out of these altogether.”

You’re certainly going to see that trend accelerate as well.

Watch the Full Conversation

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Michael Brauneis is Financial Services Industry Lead and Managing Director of Protiviti. He serves as the leader of the firm’s North American Financial Services industry practice as well as the global leader of its regulatory compliance practice.

 

 

Joseph Seidel is Chief Operating Officer of SIFMA. He manages the day-to-day operations of the Association, including core legal, regulatory, business practices, public policy, and communications activities.