Banking, climate-related financial risk, and the regulatory landscape

Gregg Anderson, Dennis Hild
Banking, climate-related financial risk, and the regulatory landscape

Climate-related financial risk is a growing concern for regulators. Financial services organizations can take proactive steps as they await guidance.

In recent months, regulatory agencies have taken preliminary actions regarding the risks associated with climate change and how the banking industry should respond. The relevant regulatory agencies have not yet issued specific guidelines or reporting requirements for financial services organizations such as banks, credit unions, and bank holding companies to follow. However, concern over climate-related financial risk is gaining momentum along with other aspects of the broader environmental, social, and governance (ESG) priorities.

As some banks and credit unions begin to develop comprehensive ESG strategies and address ESG-related risk management issues, in the absence of specific requirements, challenges remain over how best to manage climate-related financial risks as the regulatory environment evolves. Bank leaders also wonder what steps – if any – they should be taking now to prepare for anticipated future regulations governing climate-related financial risk. In this overview, we hope to help demystify the current regulatory landscape and provide banks and credit unions with some perspective as they prepare for more specific guidance and direction.

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Addressing climate-related financial risk 

Some of the early impetus for involving financial services companies in the climate change discussion developed at the global level. Various countries’ central banks and supervisors, working through international organizations such as the Bank for International Settlements and the Basel Committee on Banking Supervision, have been urging greater industry involvement in climate issues and other ESG concerns for some years.

One such effort led to the formation of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) in December 2017. Originally formed by eight central banks and supervisors, the network has since grown to include membership across five continents, including all of the U.S. banking regulatory agencies.

The network’s stated purpose is to enhance the role of the financial system in managing risks and mobilizing capital for green and low-carbon investments and environmentally sustainable development. Although the NGFS has no direct authority over U.S. banks, many of its priorities came into focus in May 2021, when President Joe Biden issued an executive order on climate-related financial risk. In addition to outlining broad policy objectives for achieving net-zero greenhouse gas emissions for the U.S. economy by 2050, the executive order specifically directed the Financial Stability Oversight Council (FSOC) to issue a report within 180 days on its member agencies’ efforts to integrate climate-related financial risk considerations into their policies and programs.

In response to the order, the FSOC issued its Report on Climate-Related Financial Risk in October 2021. The 130-page report includes more than 30 specific recommendations to U.S. financial regulators and lays out necessary actions to identify and address climate-related risks to the financial system and promote the resilience of the financial system to those risks.

With the FSOC report as a foundation, various federal banking agencies have begun taking actions that likely will shape the regulatory environment in coming years. Although they do not yet spell out specific actions for individual financial services organizations to take, these preparatory actions can provide some insights into the anticipated direction of things to come.

Preparatory actions by regulatory agencies

Even before FSOC published its report, a number of agencies and individual officials had already begun accelerating their preparatory activities and public statements related to climate-related financial risk. For example, in March 2021, the Federal Reserve (Fed) formed two separate climate committees.

The first of these, the Supervision Climate Committee, brought together senior staff from the Fed and from reserve banks across the system, with the goal of making sure that Fed-supervised organizations are resilient to climate-related financial risks. The second, the Financial Stability Climate Committee, is charged with identifying, assessing, and addressing the broader, macroeconomic aspects of climate change across the financial system, including the potential for climate-generated economic shocks.

More recently, Michael Barr, the recently sworn-in Fed vice chair of supervision, told the Senate Banking Committee that the Fed’s role in climate change issues is “important, but quite limited, quite narrow,” adding that the Fed should not be involved in directing financial services organizations on where they should or should not lend.

Shortly after the FSOC report was published, the Office of the Comptroller of the Currency (OCC) issued OCC Bulletin 2021-62, a set of draft principles outlining the agency’s proposed approach to questions related to effective risk governance frameworks, policies and procedures, and risk management practices in organizations it supervises. The initial release generated thousands of comment letters from financial services organizations and industry stakeholders, which the agency is currently reviewing and will take into account as it develops more specific requirements.

For its part, the Federal Deposit Insurance Corp. (FDIC) issued a set of draft principles for public comment in March 2022. The FDIC principles are parallel to OCC principles, and they are intended to provide a high-level framework for insured organizations to use as they begin incorporating climate-related financial risks into their risk management frameworks.

In his remarks to the Institute of International Bankers on March 7, 2022, Acting Comptroller Michael Hsu said the OCC intends to work with the FDIC and the Fed on an interagency basis so that the agencies can finalize the principles documents and begin to develop more detailed guidance, which is generally expected sometime in 2022. Although both the OCC and FDIC guidance initially would apply only to banks with more than $100 billion in assets, Hsu also added that smaller and mid-sized banks should expect comparable requirements in coming years and should “use the time wisely” to prepare.

In those same remarks, Hsu noted, “To the extent that midsize and community banks can develop thoughtful, tailored assessments of their climate risk profiles, they will help mitigate the risk of a ‘trickle down’ of large bank climate risk management expectations in the future.” More specifically, he said that “doing a ‘what if?’ scenario analysis is bread-and-butter risk management for banks” and that such practices “should be applied to climate risks in the same, objective, dispassionate way that banks approach geopolitical risk.”

In addition to the industry-specific guidance that is expected in coming months, publicly traded banks and bank holding companies also need to pay attention to the broader ESG disclosure requirements now being developed by the Securities and Exchange Commission. Although the comment period for the proposed climate-related disclosure rule closed in June 2022, uncertainty remains about when these standards will be finalized. When it eventually is completed, publicly traded companies – including publicly traded financial services organizations – likely will be required to disclose climate-related risks to their business, greenhouse gas emissions, and certain climate-related financial statement metrics.

The National Credit Union Administration (NCUA) has taken a somewhat lighter approach to climate-related financial risk management. However, its board of directors recently did include comments on the issue in its five-year strategic plan for 2022-2026: “Credit unions, not the NCUA, are best positioned to assess various risks and opportunities within their field of membership. Credit unions will need to make their own decisions on diversification and expanded fields of membership.”

Although it has not yet issued any specific guidance or draft principles for public comment, the NCUA is nevertheless a member of the FSOC, and it likely will work jointly with other banking regulators to develop a response that is generally consistent with the overall direction of the FSOC’s report on climate-related financial risk.

Next steps

With various agencies still working to finalize their general principles regarding climate-related financial risk, it is too early to speculate on the specifics of the regulatory and reporting frameworks that will eventually emerge from these efforts. The comments of Acting Comptroller Hsu and other officials assert that banks should be thinking about the impact of climate-related risks from a strategic, financial, and operational perspective, but specific steps are still unclear.

The prospects for more detailed guidance are further clouded by other elements, including the fact that many key agencies or departments currently are led by interim or acting administrators and are waiting on nominations for permanent leadership. The potential for a shift in control of the relevant legislative oversight committees adds additional uncertainty and could possibly slow the momentum or redirect some initiatives.

Ultimately, however, banks and credit unions should not wait for specific regulatory agency instructions to get started. In the long run, public and social pressures to address climate-related financial risks are likely to continue growing, so it is prudent for financial services organizations to consider their responses sooner than later – at least on a strategic level.

At a minimum, boards and executive teams should review how their current business and operational strategies address ESG topics in general and climate-related financial risks in particular. It is important that decision-makers understand the materiality of these issues in terms of their value to the enterprise and to stakeholders including customers, employees, investors, regulators, and the communities they serve. If they have not yet done so, financial services organizations should engage these stakeholder groups to gain a better understanding of their priorities. It is important to understand where various stakeholders might have conflicting priorities, and each organization will need to navigate a path through these priorities.

While specific governance requirements likely will change once the regulatory picture becomes clearer, now is an opportune time to at least confirm board ownership of climate-related financial risk issues and to identify the management functions and data reporting capabilities that might be needed. Proactively establishing baselines can make timely responses easier once specific requirements are known.

Finally, financial services organizations should remain informed about ongoing developments and provide appropriate education to all those who will be involved in the effort so that they will have the requisite knowledge to act decisively as their responsibilities evolve and become more clearly defined.

Contact us

To learn more about how your financial services organization can navigate climate-related financial risk, contact us today.
Gregg Anderson - Large
Gregg Anderson
Managing Director, Financial Services Consulting
Dennis Hild
Dennis Hild
Managing Director, Firm Risk Management