Final Climate Risk Guidance Ensures Supervisory Focus from Banking Agencies in 2024
In Short
The Situation: In October 2023, the Office of the Comptroller of the Currency ("OCC"), Federal Reserve System, and Federal Deposit Insurance Corporation ("FDIC," and the three agencies collectively, "Agencies") finalized joint guidance ("Guidance") articulating principles for climate-related financial risk management for financial institutions with more than $100 billion in assets.
The Result: The Guidance adds to the panoply of issue areas for which boards of directors and management are already responsible and will likely necessitate additional and climate risk-specific governance and risk management structures at the largest banks over time.
Looking Ahead: The Agencies are likely to scrutinize larger banks for their progress in meeting these standards as part of the Agencies' 2024 supervision process.
Background
In October 2023, the OCC, Federal Reserve, and FDIC finalized interagency guidance on climate-related financial risk management for large institutions. The Guidance includes principles providing a high-level framework for the safe and sound management of exposures to climate-related financial risks. The Guidance covers only financial institutions with over $100 billion in total consolidated assets, but—in what may be a harbinger of things to come—it notes that all financial institutions may have "material exposures" to climate-related financial risks. Although agency guidance does not have the force and effect of law, most banks will nevertheless treat it as binding, and the supervisory process may render it so as a practical matter.
Principles-Based Approach
Under the Guidance, a financial institution's board is expected to understand the effects of climate-related financial risks and hold management accountable for adhering to the institution's established risk management framework. In turn, management is expected to be responsible for, among other things, regularly reporting to the board on the level and nature of risks, including material climate-related financial risks, and incorporating such risks into relevant policies, procedures, limits, internal controls, and the processes of the institution's internal audit function.
The Guidance highlights "scenario analysis" as an important approach for "identifying, measuring, and managing" climate-related financial risks. Forward-looking assessments of the potential impact of climate change are useful in evaluating the bank's resiliency. Presumably, the Agencies' views were informed by the Federal Reserve's own experience over the course of 2023 with its first-of-its-kind climate scenario analysis program to which six of the largest U.S. banks were subjected, but the Guidance makes no mention of this program or how it may or should inform scenario analysis for those six banks or other banks.
Risk Management Across Types of Risk
The Guidance also discusses the ways in which physical and transition risks associated with climate change may impact other categories of risk:
- Credit risk: Management should consider climate-related financial risks as part of the underwriting and ongoing monitoring of portfolios. This includes credit risk monitoring, concentration risk analysis, correlation analysis across exposures and asset classes, and setting credit risk tolerances and lending limits related to material climate-related financial risks.
- Liquidity risk: Management should also assess whether and how climate-related financial risks could affect the bank's liquidity position and, if so, incorporating those risks into their liquidity risk management practices and liquidity buffers.
- Other financial risk: Management should monitor interest rate risk and other model inputs for changes in volatility or predictability, account for this uncertainty in risk measurements and controls where appropriate, and monitor the effects on exposure to price risk.
- Operational risk: Banks should assess the impact of climate-related risk on their operational risk across all business lines and operations, and should also consider climate-related impacts on business continuity.
- Legal and compliance risk: Management should consider possible changes to legal requirements for flood or disaster-related insurance. It should also ensure that existing processes to monitor compliance with fair lending requirements review whether and how any of the financial institution's potential efforts to mitigate climate risk might potentially discriminate against consumers on a prohibited basis.
Public Comments
The Agencies addressed several public comments received on their earlier proposal:
- In response to concerns that the Agencies were overstepping their legal authority by pressuring institutions to de-bank certain industries, the Agencies included their increasingly frequent disclaimer that "[t]he principles neither prohibit nor discourage financial institutions from providing banking services to customers of any specific class or type, as permitted by law or regulation."
- Although the Agencies rejected calls from some commenters to explicitly promote a transition to a lower-carbon economy, they nevertheless note that "boards of directors and management should confirm that any public statements about their financial institutions' climate-related strategies and commitments are consistent with their internal strategies, risk appetite statements, and risk management frameworks." Therefore, examiners may be placed in the role of monitoring and possibly "enforcing" public commitments by banks due to Agency concerns over bank reputation risk.
- The Agencies acknowledged but did not resolve some commenters' concerns that mitigating climate risk may result in banks retreating from low-to-moderate-income and other underserved consumers and communities. Banks may find themselves caught between safety and soundness objectives, on the one hand, and fair housing and fair lending laws, on the other.
- Finally, although the Agencies removed references to compensation practices from the final principles, they nevertheless emphasize in the preamble, which is itself a guidance document, that "sound compensation programs continue to be important to promote sound risk management and to protect the safety and soundness of financial institutions," suggesting that banks may nevertheless need to consider whether managing climate risk will warrant changes to compensation policies.
Related Government Actions
The Guidance is consistent with efforts underway across other federal and state government agencies. The Financial Stability Oversight Council ("FSOC") identified climate change as an emerging threat to U.S. financial stability in 2021, and has reiterated its concerns repeatedly, including in its most recent annual report in 2023. It has issued specific reports on the topic and formed two related committees: a staff-level Climate-related Financial Risk Committee to "build capacity, address data gaps, and improve methodological approaches to risk monitoring," and an external Climate-related Financial Risk Advisory Committee to "provide[] the Council with information on and analysis of climate-related financial risks from a broad array of perspectives."
The U.S. Treasury, whose Secretary chairs the FSOC, issued its "Principles for Net-Zero Financing and Investment" in September 2023, marking the first time a major U.S. government agency has provided guidance to the financial sector regarding the development and implementation of net-zero transition plans.
Not to be outdone by its Federal peers, the New York Department of Financial Services issued its own final guidance relating to management of material financial and operational risks from climate change in December 2023.
Although some of these documents and actions are hortatory rather than mandatory, to the extent they are issued or conducted by an agency with supervisory powers, it is almost certain that entities within such agency's authority will feel pressure to comply.
Three Key Takeaways
- With the Guidance finalized, the Agencies will increase their supervisory scrutiny of financial institutions' efforts to manage climate risk, which is likely to result in individual feedback to banks through the supervisory process and, potentially, Agency criticisms of banks in the form of matters requiring attention for particularly deficient practices.
- Given the nascent and evolving nature of supervisory expectations on climate risk management, the Agencies may employ a horizontal approach in which larger banks are "graded" against one another, making it hard for banks to predict in advance the standards to which they will be held and creating circumstances that promote a "ratchet effect" of rising standards over time.
- To reduce the risk of supervisory criticism and facilitate examination, banks, particularly the largest banks, should consider developing and documenting a road map for implementing the principles in the Guidance.
