New York Fed – Liberty Street Economics, Hyeyoon Jung: “A growing number of climate-related policies have been adopted globally in the past thirty years (see chart below). The risk to economic activity from changes in policies in response to climate risks, such as carbon taxes and green subsidies, is often referred to as transition risk. Transition risk can adversely affect the real economy through the banking sector. For example, a shock to borrowers’ transition risk can impair their ability to repay, which can then lead to an amplified effect on banks’ current and expected future profits, resulting in a systemic undercapitalization of banks. In a recent Staff Report co-authored with Robert Engle and Richard Berner, we examine whether banks are sufficiently capitalized to absorb losses during stressful conditions due to heightened climate (transition) risk…We develop a novel measure, CRISK, defined as the banks’ expected capital shortfall conditional on climate stress. The capital shortfall is taken as the capital reserves the financial firm needs to hold to meet prudential capital requirements. CRISK is a function of a given financial firm’s size, leverage, and the expected equity loss conditional on climate stress. As shown in the chart below, the latter is computed using the estimated climate beta and an assumption regarding the level of climate stress. To consider a sufficiently severe yet plausible stress scenario, we take the lowest one percentile of the six-month return distribution of the climate risk factor to calibrate the stress level…”