Regulators’ Efforts To Promote Climate Risk Management by Banks Are a Positive Step Forward
Risk management is a critical concern for both banks and the regulators that supervise them. Banks take on a variety of risks in the course of their business operations. For example, credit risk can arise when a bank lends to borrowers who are unable to pay back their loans, and liquidity risk can occur if a bank is forced to sell assets at a significant loss in order to meet its debt obligations—for example, if there is a run on the bank and it does not have the cash that depositors are demanding. Although risk management is important for banks to protect themselves from losses and insolvency, it is also a significant public policy concern; the fact that the government insures bank deposits and that a single institution’s failure can have systemic effects necessitates an active role for regulators.
One area where bank regulators must act is addressing climate-related financial risks—those risks stemming from the consequences of a warming planet. In particular, climate change can cause physical risk as extreme weather and other climate events cause losses to financial assets, as well as transition risk as government policies, private actions, and business practices change to adapt to a low-carbon economy. These risks are sufficiently serious that the Financial Stability Oversight Council has identified climate change as an “emerging threat to financial stability.”
Climate change poses a threat to the well-being of not only the environment but also financial markets and institutions.
Banks’ central role in the economy exposes them to these risks in a way that requires prudent management, and in recognition of this fact, the Federal Deposit Insurance Corporation (FDIC) recently issued a proposed set of principles for large banks under its supervision to identify and address climate-related risks to their businesses. The FDIC’s proposal closely follows a similar document issued by the Office of the Comptroller of the Currency (OCC) last December.
If made final, the principles proposed by the FDIC—and OCC—would mark a positive step forward in making sure that banks identify the risks posed to their businesses by climate change and take tangible actions to manage those risks. The proposed principles describe how banks should integrate climate risk management into several aspects of their businesses, including governance (i.e., the board and senior managers), policies and procedures, strategic planning, and risk management. They also call on banks to engage in scenario analyses that would examine their institutions’ vulnerability to a variety of potential climate-related events. These actions are critically important for banks of all sizes to take proactive steps to mitigate risks before the problem becomes even more severe.
Furthermore, the FDIC appropriately made clear that its focus on climate-related financial risks is about safety and soundness concerns, writing: “Weaknesses in how institutions identify, measure, monitor, and control the physical and transition risks associated with a changing climate could adversely affect a financial institution’s safety and soundness, as well as the overall financial system.” Because of the vital importance of banks’ safety and soundness not only to their customers but also to the overall financial system and economy, the FDIC has broad regulatory and supervisory authorities to ensure that banks take action to protect their operations and balance sheets.
When financial markets and institutions fail, it is usually society’s least well-off who suffer the most in the ensuing economic fallout.
In a comment letter to the FDIC about its proposed principles, the Center for American Progress offered the following recommendations for the FDIC to consider as it finalizes its guidance and issues future climate-related guidance documents:
- Given that all banks face climate-related financial risk, the FDIC’s principles must be sufficiently high level so that they apply to all banks, not just banks above $100 billion in assets. Implementation of the principles, both through guidance documents and examinations, can be tailored based on a bank’s size and business lines, but all banks should follow the main principles.
- The FDIC must explain to banks how climate risks are interconnected and relate to traditional financial risks, while also providing guidance as to how climate-related financial risks fit into the framework used by examiners to rate banks—known as CAMELS.
- The FDIC must require banks to fulfill their public commitments regarding climate, particularly regarding net-zero pledges and the use of carbon offsets.
- The FDIC should issue guidance relating to the impact of climate risk mitigation on low- and moderate-income (LMI) communities, including by detailing how institutions may continue extending credit to vulnerable communities in a safe and sound manner; working with the other federal banking agencies to update their Community Reinvestment Act (CRA) rules to ensure that credit flows to LMI and other disadvantaged communities to help them reduce their fossil fuel emissions and protect themselves from climate impacts; and ensuring that banks consider whether their climate risk mitigation efforts have fair lending implications.
- The FDIC should work with the OCC and the Federal Reserve Board to amend their call reports and any other required reports to include relevant fields related to banks’ climate-related financial risks.
- The FDIC must begin conducting scenario analyses quickly, even if the first scenarios are somewhat simplistic. Moreover, it must provide multiple scenarios to banks describing orderly and disorderly transitions and ensure that banks’ models are sufficiently rigorous and avoid obvious pitfalls such as “model shopping.” Both large and regional banks should participate in scenario analyses.
Climate change poses a threat to the well-being of not only the environment but also financial markets and institutions. And when financial markets and institutions fail, it is usually society’s least well-off who suffer the most in the ensuing economic fallout. Accordingly, the FDIC and other bank regulators—including the Federal Reserve, which should likewise issue similar guidance for the banks and bank holding companies it supervises—must act with urgency to make sure that banks are aware of the risks climate change poses to their businesses and are taking plausible actions to mitigate those risks.
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Director, Financial Regulation and Corporate Governance