Climate risk, or the risk that climate-related changes pose to financial institutions, is demanding more and more attention from researchers, regulators and boards of directors
What are the federal regulatory agencies saying about climate risk? And what are the key areas your board and senior management should begin thinking about?
What the Feds say
In May 2021, the President’s Executive Order on Climate-Related Financial Risk encouraged financial regulators to assess climate-related financial risk to the U.S. government and its financial system. The order calls for a report including plans to prove climate-related disclosures and other sources of data, and to incorporate climate-related financial risk into regulatory and supervisory practices. The Financial Stability Oversight Council (FSOC) released a report on climate-related financial risk in late 2021.
- OCC | Among the federal financial regulators, the Office of the Comptroller of the Currency is most actively researching climate-related financial risk management. From seeking out academic research to input on draft principles for developing guidance for institutions with more than $1 billion in assets, the agency is concerned that “weaknesses in how banks identify, measure, monitor and control potential climate-related financial risks could adversely affect banks’ safety and soundness, as well as the overall financial system.” The OCC appointed its first Climate Change Risk Officer, Darrin Benhart in July 2021.
- The Fed | In 2021, the Federal Reserve created the Supervision Climate Committee to bring together senior staff across the Federal Reserve Board and Reserve Banks to help understand how climate change might impact financial institutions, infrastructure and markets.
- FDIC | Earlier this year, the FDIC released an outline for how large banks should measure and plan for climate change risks. The FDIC also proposed that big banks create climate “dashboards” that include exposure analysis to both physical and credit risks of climate change, as well as other risk measurements.
Financial institutions don’t just engage in risk management because regulators expect them to; they do it because it is a best practice essential for strategic success. Banks, mortgage companies, fintechs (and credit unions) should pay attention to climate risk as an emerging risk and consider how it may impact their business and operating environment going forward.
Two Climate Risk Areas to Consider:
- Physical risks | Physical risks include the increased frequency, severity and volatility of extreme weather, long-term shifts in global weather patterns and the resulting impact on the value of financial assets and borrowers’ creditworthiness.
- Transition risks | Transition risks relate to how the world adapts to climate risk. This includes climate policies and regulation, technological innovation, and consumer and investor sentiment.
An important first step in managing climate risk is identifying the borrowers and sectors most likely to see deterioration in their ability to repay or in their collateral values due to physical risks (such as wildfires and natural disasters) and transition risks (such as how green energy initiatives impact companies dependent on fossil fuels for growth).
Additionally, communities with fewer resources are more likely to feel the impact of climate change, the report from FSOC warns. These communities may experience higher insurance and credit costs or the inability to obtain insurance or credit as a result.
Climate risk modeling and stress testing
Currently, The Federal Reserve is developing scenario analysis to model the possible financial risks associated with climate change and assess the resilience of individual financial institutions and the financial system to these risks. These models account for both transition and physical risks and will differ based on region and sector.
According to Federal Reserve Governor Lael Brainard, “Since financial markets are forward looking, a change in expectations regarding climate-related risks could lead to a sharp repricing of assets at any time.” Brainard notes that it will take time to build accurate models because many aspects are currently hard to predict.
Business continuity and disaster recovery
Business continuity and disaster recovery planning is always important, but as the likelihood of extreme weather events grows, financial institutions will want to be increasingly aware of how that could impact data centers and other critical services. In many cases, this requires due diligence on the review of third-party vendors providing these services. Risk assessments need to consider this possibility and how an institution could mitigate these risks.
Uncovering the opportunities that new risks present
Financial institutions that practice good risk management know that every risk presents opportunities to those with the foresight to be prepared. Climate-related changes in agriculture, water infrastructure and consumer and investor preferences can create opportunities. According to the OCC Acting Director Michael Hsu, banking opportunities will include renewables, carbon capture, electric vehicles and charging stations.
Early adopters of climate risk management will be in the best position to identify and maximize these opportunities. They will have a strong understanding of how climate risk could impact their communities, customers, institutions and the economy at large and develop strategies to navigate this emerging risk. Financial institutions must make sure their board and senior management are keeping an eye on climate risk and are taking the time to consider climate-related issues.
Michael Berman is founder and CEO of Ncontracts.