How Uncovered Are U.S. Banks’ Mortgage Portfolios to Local weather Transition Dangers?

Hyeyoon Jung, João A.C. Santos, and Lee Seltzer

Editor’s observe: Since this submit was first revealed, the y-axis labels within the first 4 charts have been corrected. July 10, 12:30 p.m.

A lot of the work on local weather threat has centered on the bodily results of local weather change, with much less consideration dedicated to “transition dangers” associated to destructive financial results of enacting climate-related insurance policies and phasing out high-emitting applied sciences. Additional, a lot of the work on this space has measured transition dangers utilizing backward-looking metrics, reminiscent of carbon emissions, which doesn’t permit us to match how completely different coverage choices will have an effect on the economic system. In a current Workers Report, we capitalize on a brand new measure to check the extent to which banks’ mortgage portfolios are uncovered to particular local weather transition insurance policies. The outcomes present that whereas banks’ exposures are significant, they’re manageable.

Basic Equilibrium Method

We exploit estimates from basic equilibrium fashions of the lower in output or earnings of given industries on account of sure local weather transition insurance policies. This method permits us to match a broad set of local weather transition insurance policies whereas accounting for spillover results between completely different industries that can not be noticed utilizing historic information. As well as, and in contrast to earlier work utilizing historic information on carbon emissions, estimates from basic equilibrium fashions are forward-looking in nature.

We introduce two of the three estimates we use in our paper. The primary builds on Jorgenson, Goettle, Ho, and Wilcoxen (2018), which gives estimates of the projected lower in {industry} output on account of carbon taxes. The authors think about 4 eventualities, with the least stringent being a $25 preliminary carbon tax and a 1 % tax development fee, and the strictest being a $50 preliminary carbon tax and a 5 % tax development fee.

For the second, we think about the G-Cubed mannequin estimates of projected modifications in {industry} output for the Community for Greening the Monetary System (NGFS) eventualities, or NGFS (2022). The mannequin gives three eventualities designed to achieve a specific coverage objective. An orderly transition state of affairs assumes that coverage is straight away enacted to transition the economic system to net-zero emissions by 2050. A disorderly transition state of affairs assumes nothing is finished till 2030, at which level coverage is enacted to restrict the end-of-century temperature rise to 2 levels Celsius. The final state of affairs assumes that present local weather coverage is maintained.  

Utilizing the eventualities in each fashions, we calculate banks’ exposures to transition dangers because the lower within the worth of their mortgage portfolios. When calculating the measure, we assume financial institution mortgage values drop proportionally to the lower in {industry} output or gross sales estimated by the final equilibrium mannequin used. We calculate these exposures for each fashions, and for all of the coverage choices supplied in every.

Banks Exposures to Transition Dangers over Time

The 2 charts beneath plot the common financial institution publicity over time. The primary set of estimates (first chart) replicate the preliminary tax degree and development fee eventualities from Jorgenson et al. (2018). For all eventualities, banks’ exposures have been comparatively steady over time. Moreover, these exposures are comparatively modest, starting from about 1.0 % to only beneath 3.5 % as of 2022, relying on the state of affairs.

Financial institution Exposures from Jorgenson et al. (2018) over Time

Exposures for the G-Cubed mannequin estimates of modifications in output for every of the NGFS eventualities (subsequent chart) are considerably greater beneath the orderly and disorderly transition eventualities than beneath present coverage, reaching an publicity of about 9 % as of 2022. Moreover, banks’ exposures beneath these eventualities lower considerably over time throughout our pattern interval, from about 13 % in 2012 to 9 % in 2022.

Financial institution Exposures from NGFS G-Cubed over Time

Banks’ Exposures to the Most Transition Coverage–Delicate Industries

Within the evaluation above, we used the estimated declines in {industry} output produced by the final equilibrium fashions. An alternate method can be to contemplate a framework by which loans to essentially the most transition coverage–delicate industries finally change into nugatory. To implement such an method, we calculate various publicity measures assuming that the worth of loans in both the highest decile or prime two deciles of publicity goes to zero if the modeled coverage is enacted, whereas nonetheless assuming that loans to different industries lower on the similar fee because the decline in output estimated by the final equilibrium fashions.

Once we assume that loans to the highest decile of industries go bankrupt, banks’ exposures improve by about 4 share factors based mostly on the estimates from Jorgenson et al. (2018). Once we assume that loans to the highest two decile industries go bankrupt, banks’ exposures improve by one other 6 share factors. Over time, the exposures to essentially the most policy-sensitive industries seem like declining. Utilizing the estimates from NGFS (2022), there’s a much less stark distinction throughout eventualities. It is because the G-cubed mannequin of the NGFS eventualities assumes that beneath the disorderly state of affairs, output for essentially the most delicate industries will finally lower to zero. Primarily based on these estimates, we additionally discover that the exposures are mildly falling over time.

Financial institution Exposures to the Most Transition Coverage–Delicate Industries from Jorgenson et al. (2018) over Time

Financial institution Exposures to the Most Transition Coverage–Delicate Industries from NGFS G-Cubed over Time

How Do Banks Handle Transition Dangers

The charts above point out that banks’ exposures to essentially the most transition coverage–delicate industries have declined. To raised perceive how banks are managing local weather transition dangers, we break financial institution mortgage portfolios into three classes based mostly on their coverage sensitivities: high-sensitive industries (prime 2 decile decline in {industry} output), low-sensitive industries (backside 2 decile decline in {industry} output), and medium-sensitive industries (all different industries). We then plot financial institution lending by industry-sensitive exposures for the Jorgenson et al. (2018) and NGFS (2022) fashions. In each plots, we normalize every publicity measure to equal 1 within the third quarter of 2015, and research modifications in publicity across the Paris Settlement within the fourth quarter of 2015. As proven within the two charts beneath, banks seem to have elevated their exposures to industries with comparatively low local weather transition threat exposures and to have decreased their exposures to industries with excessive local weather transition threat exposures. Collectively, these charts recommend that banks on their very own could also be adjusting their lending portfolios each by lending extra to “greener” industries and by lending much less to “browner” industries.

Financial institution Exposures by Coverage Sensitivity for Jorgenson et al. (2018)

Financial institution Exposures by Coverage Sensitivity for NGFS (2022)

Remaining Phrases

On this submit and this paper, we use insights from basic equilibrium fashions to estimate how uncovered banks’ mortgage portfolios are to completely different local weather transition insurance policies. We discover that the exposures are significant, however manageable. Moreover, we discover that exposures to essentially the most transition coverage–delicate industries seem to have decreased over the past a number of years. Going ahead, will probably be fascinating to know whether or not industries which are badly uncovered to transition insurance policies are being shut out of economic markets, or whether or not they’re able to make up for a possible discount in financial institution credit score by elevating funding elsewhere.

Hyeyoon Jung is a monetary analysis economist in Local weather Threat Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.  

João A.C. Santos is the director of Monetary Intermediation Coverage Analysis within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.

Lee Seltzer is a monetary analysis economist in Local weather Threat Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group. 

Methods to cite this submit:
Hyeyoon Jung, João A.C. Santos, and Lee Seltzer, “How Uncovered Are U.S. Banks’ Mortgage Portfolios to Local weather Transition Dangers?,” Federal Reserve Financial institution of New York Liberty Avenue Economics, July 10, 2023, https://libertystreeteconomics.newyorkfed.org/2023/07/how-exposed-are-u-s-banks-loan-portfolios-to-climate-transition-risks/.