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Fed calls on financial firms to improve transparency for climate risks

The Federal Reserve has added climate change to its list of risks to the financial system, calling on financial firms to improve transparency on how they price climate risks. Yahoo Finance's Brian Cheung discusses.

Video Transcript

MYLES UDLAND: All right, let's turn our attention to the Federal Reserve and some news we got from the Central Bank yesterday after the market closed. Brian Cheung joins us now for that conversation.

Brian, the Fed putting out its latest financial stability report. And in there, as you noted, for the first time is the Fed mentioning climate change as a risk to financial stability, which is a way of saying, in technical terms, the future of the economy.

BRIAN CHEUNG: Well, as you mentioned, Myles, a pretty notable development in the way that the Federal Reserve is approaching what they call financial stability risks. As you mentioned, yesterday in a report, the Fed says it's evaluating and investing in ways to explore the impact of severe weather events and rising sea levels. They listed climate change as a risk to financial stability.

And what does this have to do, I guess is the question, with the Fed's dual mandate of maximum employment and price stability. Well, the report lays out a domino effect that could happen. Think about pricing in real estate, for example, right? Some properties might not be appropriately pricing in the risk of things like storms or floods or wildfires.

So if there were to be some sort of large event that would strike, it could lead to a massive repricing of those types of assets that could push valuations down and trigger, possibly, fire sales, which would then ripple up to the mortgage-backed securities that those are looped into, and then, ultimately, up to the leveraged financial firms, shadow banks or not, that ultimately hold onto them.

So Lael Brainard, the Fed governor who's really been spearheading this effort, said in a statement yesterday, quote, "it is vitally important to move from the recognition that climate change poses significant financial stability risks to the stage where the quantitative implications of those risks are appropriately assessed and addressed." Again, that coming from Fed Governor Lael Brainard, who, I should mention, is also under consideration to be a possible Treasury Secretary under the Biden administration.

But the real gist of her quote there is that the Federal Reserve could be asking financial firms for more transparency quantitatively in the way that they're approaching these climate risks. A pretty large development for the Federal Reserve that has been mostly mum on climate change over the past few years.

- Hey, Brian. It's interesting that they're coming to this decision. And I wonder if we have any transparency-- speaking of transparency-- about how they got there. Because we've heard an increasing number of investment firms and banks say that they want this information for investment purposes, not so much for risk purposes, but for investment purposes. Do you think that the Fed might have gotten some feedback from some of their constituents that led to this?

BRIAN CHEUNG: Well, I think what you're probably hinting at is that the trend towards ESG, where the environmental part, the "E" part of that ESG, has really been the wave, really, in investing for the past few years. That's definitely been true.

But I think what the Federal Reserve is saying here is not so much whether or not investing trends into those types of businesses is really something they're worried about. I think it's more so that worry that the financial system-- banks, non-banks-- are not appropriately pricing certain types of assets for the possible events that could be happening in the future. Obviously, a lot of bankers come from kind of business schools where they don't allow you to really-- or really train you, so far, in being able to price in these types of things, like storms or wildfires.

Obviously, the insurance industry has had some experience in that. But there's not as much overlap between the insurance industry and traditional banking. So if the banks are not appropriately priced for these things, then these types of fire sales-- for example, if there were to be some sort of large hurricane in an area that's never experienced it before-- could lead to some sort of, not asset bubble, per se, but actually de-pricing that could really destabilize anything that's really wrapped up into those securities.

So I think that's what the Federal Reserve is zoned in on-- zoned in on. What's really unclear is how the Federal Reserve would actually approach this through new regulation. It's not so clear beyond what Brainard had said in that statement yesterday.

MYLES UDLAND: Yeah, and I'm not really sure that they really have any good ideas on that. But, I guess, you know, if you look at what the Powell Fed has done with the listening tour, they're changing how they disclose some of their materials. Is this kind of statement within the Financial Stability Report, which is, again, a regularly scheduled part of Fed programming. Do you think this is the-- the Powell Fed seeing its role as, let's call it, a "thought leader," to use that term, differently within the context of how bankers-- central bankers, investment bankers-- think about systemic risks, and who is supposed to be calling the-- or sounding the alarm first?

Because, you go back in time, the Fed has traditionally been late to that game. It seems like this is a different tactic for them.

BRIAN CHEUNG: It could be. But I think in the span of, you know, whether or not they've been the last to go in the global central banking world, they actually are behind the ball on this. So the European Central Bank, the Bank of England-- Mark Carney was very vocal on these types of things. In fact, he spent most of his Jackson Hole speech last year focused on this type of topic. Jerome Powell has not really said much on this topic. He's mostly left it up to Lael Brainard to take on this role.

And again, this is the first time, in this Financial Stability Report, that it's really been codified into their list of risks that are being public he stated. So the Federal Reserve is actually behind the ball, relative to other central banks.

There's actually an organization called the MGFS. I may have mixed up the order of those letters. But it's a coalition of other central banks around the world that are focused on a more greener sustainable future. The Federal Reserve was not an official member of that, although they are under consideration for joining that right now. But again, they're actually a few years behind the other central banks. But I guess, from Lael Brainard standpoint rather late than never.