US Fed board proposes plan for banks to manage financial risk

The US Federal Reserve board joined other key banking regulators in proposing a plan for how large banks should manage climate-related financial risks, drawing immediate dissent from one member and reservations from another.

The proposed principles detailed expectations for banks with more than $100 billion in assets to incorporate financial risks related to climate into their strategic planning. Issuance of the proposal for public comment was approved in a 6-1 vote of the Fed Board of Governors.

The proposal marks the latest effort by US policymakers to gird for potential financial risks from climate change, bringing the Fed into alignment with the Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC), which have separately proposed their own plans.

The potential effects of climate change - rising sea levels, worsening floods and fires, and government policies transitioning away from carbon-heavy industry - could destroy trillions of dollars of assets around the globe.

Those financial impacts “pose an emerging risk to the safety and soundness of financial institutions and the financial stability of the United States,” the Fed said.

The Fed’s plan would require banks to consider climate-related financial risks in their audits and other risk management and add climate-related scenario analysis to traditional stress testing. Banks should also assess whether they should include climate-linked risks into their liquidity buffers and consider, it proposed.

The debate over the extent of financial system risks posed by climate change has been politically charged. Fed Governor Christopher Waller dissented against Friday’s proposal, raising the question of whether it poses a serious risk to large banks’ soundness or US financial stability.

“Climate change is real, but I disagree with the premise that it poses a serious risk to the safety and soundness of large banks and the financial stability of the United States,” Waller said in a statement released alongside the proposal. “The Federal Reserve conducts regular stress tests on large banks that impose extremely severe macroeconomic shocks and they show that the banks are resilient.”

Governor Michelle Bowman supported the plan to seek public input with reservations, noting the Board should consider “the costs and benefits of any new expectations”.

The proposal will be open for public comment for 60 days. Meanwhile the Fed hawkishness make US stocks unattractive in comparison with other developed markets, the bank said, naming the UK as its top pick.

BoFA Global Research expects US equities to end broadly flat in 2023 but sees prices for gold rallying up to 20%, aided by a falling dollar. Raw materials such as gold are priced in dollars and become more attractive to foreign buyers when the greenback declines.

Citi, meanwhile, said recession fears and weaker earnings growth will hurt US stocks in 2023 and advised clients to “treat rallies in US equities as bear market rallies.” By contrast, they are overweight China, expecting Chinese stocks to receive a boost from loosening COVID-19 restrictions and government support for the real estate sector.

Fourth-quarter earnings for the S&P 500 are expected to fall 0.4% compared with the same time period last year, before rebounding over the course of the year and hitting a 9.9% growth rate in the fourth quarter of 2023, according to Refinitiv data.

Investors in the coming week are awaiting economic data on the US services sector, which grew at its slowest pace in nearly 2-1/2 years in October.

Not everyone believes that recession is a given. Signs of ebbing inflation have fueled hopes that the Fed may tighten monetary policy less than expected, supporting a rebound in the S&P 500 that has buoyed the index from its October low.

Lucas Kawa, an asset allocation strategist at UBS, believes stock prices are already factoring in recession risk. He expects some of the factors that hurt markets in 2022 - including weaker growth in China and Europe - to reverse next year, supporting asset prices.

“There’s a good chance that 2022’s headwinds are going to turn into 2023’s tailwinds,” he said.

Garrett Melson, a portfolio strategist at Natixis Investment Managers, expects a so-called soft landing in which the US economy grows at a moderate pace, with higher interest rates weighing on consumers without completely squashing spending.

He is bullish US small-cap stocks, which he believes have priced in a recession. The small-cap Russell is down some 16% this year.

“The market seems a little offside here with the consensus that a recession is inevitable,” he said. “The path to a soft landing is probably wider than what the consensus viewpoint is right now.”