Banks Must Prepare for Climate Change — Regulators Finally Say How

ESG can lead to a thicket of political controversy. But in releasing joint guidance on how banks should be addressing climate risk, the federal regulatory agencies managed to steer clear of inflammatory issues. Here's what you need to know about the long-awaited guidance — including an outline of what the agencies expect from banks and their boards.

After a series of fits and starts, the Federal Reserve Board, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency issued long-awaited climate guidance on October 30, 2023.

The guidance sets forth supervisory expectations rather than prescriptive rules and is directed primarily at banking organizations with at least $100 billion in assets. But even smaller financial institutions should take note, as a signal of where supervisory questions may lead in the coming months and years.

With these “Principles for Climate-Related Financial Risk Management for Large Financial Institutions,” the banking agencies meet the stated goal of providing a “high-level framework” for understanding the effective management of climate-related financial risks.

The guidance offers enough insight that bankers wondering how to get started could use it to craft a checklist for tweaking their risk management process. They could also take some comfort in knowing that there are no surprises lurking — the guidance might be new, but the governance standards it contains are not.

Here’s an overview of the basics.

Climate Risk for Banks Is Not Just About the Weather

According to the banking agencies, climate-related risks fall generally into two categories.

The first, “physical risks,” refers to damage that results from specific weather events, such as hurricanes and heat waves, or “chronic shifts in climate” — changes in sea levels and average temperatures, for example.

The second, “transition risks,” refers to broader economic and financial impacts as industries, sectors, companies, and consumers shift to a “lower carbon economy.”

For both categories, the principles address only financial risks related to climate change and only to the extent such risks concern banking institutions’ overall safety and soundness.

The banking agencies take pain to note that, in issuing the principles, they do not wish to discourage providing banking services to particular types of companies or industries (e.g., oil and gas companies, extractive industries) or to influence underwriting or business decisions more broadly (e.g., by encouraging lending to the “green economy”).

Within this framework, the principles describe six areas where financial institutions should consider climate change as part of their overall risk management. While the climate may be a new risk to evaluate, the rest will feel familiar to bank executives and directors.

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Banks Should Treat Climate Like Other Risks

In each of the following six areas, the principles incorporate standards and expectations that appear in guidance across the bank regulatory canon:

1. Governance

It is the responsibility of boards to understand climate-related financial risks, set the institution’s risk appetite accordingly, and oversee management’s execution of strategies for managing financial risks facing the institution because of climate change. At the same time, it is management’s responsibility to design and implement a risk management plan consistent with the board’s vision and keep the board informed with timely, accurate, and actionable data.

2. Policies, Procedures, and Limits

Management should integrate climate-related risk management policies into the larger system of policies and procedures the institution uses to manage other financial risks.

3. Strategic Planning

Climate-related risk should play a role in determining the board’s long-term strategic plan for the financial institution. The principles also encourage boards to consider the impact that their activities may have on “low- and moderate-income communities.”

4. Risk Management

Banking organizations should implement processes for identifying, measuring, and keeping internal stakeholders fully informed regarding material climate-related risks facing the institution.

5. Data, Measurement, and Reporting

Management should ensure that data collection and reporting procedures are capable of providing reliable information regarding the financial risks an institution faces due to climate risk.

6. Scenario Analysis

Banks should engage in scenario analysis specifically designed to assess the potential impact of climate-related risks, considering both transitory shocks (as in traditional stress testing) and structural changes to the economy and financial system resulting from climate change. Because these risks are evolving and dynamic, institutions should be similarly flexible and adaptable in conducting scenario analysis.

The principles also note that climate-related risks likely impact other categories of financial risk categories that banking organizations monitor in the normal course — credit risk, liquidity risk, operational risk, legal and compliance risk, etc. In all of these areas, financial institutions should account for the incremental additional risks presented by climate change.

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Take a Cue from the Banking Regulators

During a year marked by some of the largest bank failures in American history, and with the federal bank regulatory agenda as full as it has been since the financial crisis of 2008-2009, the release of these principles from the Fed, the FDIC and the OCC attracted less attention than they might have at another time. The banking agencies also appear to have crafted the principles to avoid political debates regarding environmental, social and governance topics, or ESG.

But don’t equate the relative quiet with a lack of importance. The principles address areas that all banking organizations would do well to think about carefully — the regulators certainly are.

David Sewell is a regulatory lawyer at Freshfields Bruckhaus Deringer advising banks, nonbank financial institutions, and fintech companies. Cates Saleeby is a law clerk at the firm.

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