New Federal Climate Change Guidance for Large Banks Outlines Risk Management Framework

The guidance, Principles for Climate-Related Financial Risk Management for Large Financial Institutions, is intended for banks with more than $100 billion in assets. The agencies recognized that these institutions are likely to be negatively impacted by two types of risks associated with climate change:

1. Physical risks, or “the harm to people and property arising from acute, climate-related events, such as hurricanes, wildfires, floods, and heatwaves, and chronic shifts in climate, including higher average temperatures, changes in precipitation patterns, sea level rise, and ocean acidification.”
2. Transitional risks, or “stresses to institutions or sectors arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes that would be part of a transition to a lower carbon economy.” The agencies also recognized that climate change could disproportionately impact the “financially vulnerable, including low-and-moderate-income (LMI) and other underserved customers and communities.”

The agencies’ guidance comes on the heels of a report by the Financial Stability Oversight Council (FSOC) that declared “climate change is an emerging threat to the financial stability of the United States.” Acting Comptroller of the Currency Michael Hsu recently said. “We should not wait for a disaster to strike before we act. Prudence demands we act as risks emerge.” Both actions are a clear response to Republican pushback against federal efforts to address the financial impacts of climate change.

Framework for Managing Financial Risk

The principles issued by the financial regulatory agencies aim to “provide a high-level framework for the safe and sound management of exposures to climate-related financial risks.” They are not meant to dictate decisions regarding whether to make a loan or to open, close, or maintain an account.

The framework’s principles on management of climate-related financial risks cover these areas: governance; policies, procedures, and limits; strategic planning; risk management; data, risk measurement, and reporting; and scenario analysis. Here is a summary of some of the important principles:

• Board and Management Involvement. The agencies expect a bank’s board and management to understand the bank’s exposure to risks from climate change and to consider those risks when determining the institution’s overall business strategy.
• Data, Risk Measurement, and Reporting. The principles identified several tools and approaches that should be utilized to measure and monitor climate risk exposure, including “exposure analysis, heat maps, climate risk dashboards, and scenario analysis.” According to the guidance, outputs from these tools “should inform the risk identification process and the short- and long-term financial risks to a financial institution’s business model from climate change.” The principles also recommended that bank management “incorporate climate-related financial risk information into the financial institution’s internal reporting, monitoring, and escalation processes to facilitate timely and sound decision-making across the financial institution.”
• Climate-Related Scenario Analysis. The guidance defined “climate-related scenario analysis” to mean “exercises used to conduct a forward-looking assessment of the potential impact on a financial institution of changes in the economy, changes in the financial system, or the distribution of physical hazards resulting from climate-related financial risks.” The principles dictated that financial institutions take into account their size, complexity, business activity, and risk profile.
• Risk Management. The principles described how climate-related financial risks could be addressed in the management of several traditional risk areas, including credit, market, liquidity, operational, and legal risks.

In issuing the guidance, the agencies also responded to several categories of comments regarding the principles. Commenters requested guidance on how financial institutions should determine whether climate-related financial risks are material, and whether financial institutions can make their own materiality determinations. The agencies did not provide further guidance on how to determine if a risk is material, but clarified that a bank’s management should incorporate climate-related financial risks into their risk management frameworks where those risks are material. They also stated that the “principles provide that financial institutions’ management should employ comprehensive processes for identifying climate-related financial risks consistent with methods used to identify other types of emerging and material risks.”

While the guidance is high-level in nature, it signals that agencies are serious about large financial institutions adopting climate-related financial risk management procedures, especially at the governance level. The agencies also recognized that all financial institutions could face material climate-related risks, even though the guidance is tailored towards large institutions, and also emphasized the importance of considering the impact on LMI and other underserved communities and their access to financial products and services. Given that several regulators expressed the importance of banks’ ability to meet the changing needs of the communities they serve, we may expect climate risk and sustainability issues to be incorporated in some manner going forward, even for smaller institutions. We also expect states and regulating entities to continue to develop climate-risk related rules, such as the recent California Climate-Related Financial Risk Act (SB261), the proposed amendments to the Federal Acquisition Regulation that would require Federal contractors to disclose climate related risk and set carbon reduction goals, and the pending SEC rules.

Members of the firm’s Environmental and ESG teams regularly monitor state and federal administrative activity with broad implications to the regulated community and advise clients on understanding the risks and benefits posed by an increased focus on emerging ESG standards at the corporate level.