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Coming Soon: Climate Risk Supervision for Banks

The risks of climate change are top of mind right now.

On October 21st, the Financial Stability Oversight Council (FSOC) issued a Report on Climate-Related Financial Risk.  This report is in response to the May 2021 Executive Order on Climate-Related Financial Risk. There’s a lot to wade through here, including 35 specific recommendations.

But even at this preliminary stage, two things are clear. First, the report recognizes that climate change is a risk to financial stability in the U.S. and encourages all member agencies to act promptly to begin addressing these risks. Second, financial services firms and insurers would be well-advised to begin thinking about climate risk now, if they haven’t already. 

State and Federal regulators have underscored the urgency: in response to The Glasgow Declaration issued by the Network for Greening the Financial System (NGFS) at the COP26 meeting, both the Fed and the OCC issued statements in support. New York’s Department of Financial Services was the first U.S. regulator to join NGFS, and, also following COP26, announced the creation of a Climate Risk Division.

The FSOC report’s 35 recommendations fall into four broad categories:

  1. Building capacity and expanding efforts to address climate-related financial risks
  2. Filling climate-related data and methodological gaps
  3. Enhancing public climate-related disclosures
  4. Assessing and mitigating climate-related risks to financial stability

The report includes specific recommendations related to climate change data, disclosure and scenario analysis. It encourages agencies to leverage the Task Force on Climate Related Disclosures (TCFD) disclosure work and the NGFS scenario analyses. Coordination across member agencies and in international forums is a big theme.

The report also acknowledges that financially vulnerable communities will probably bear a disproportionate share of the adverse effects of climate change and encourages agencies to coordinate analysis of climate-related financial risk with efforts to understand impacts on communities and households. 

In addition to the recommendations, the report acknowledges a number of impediments to assessing and addressing climate-related financial risk, including:

  • Data limitations – specifically connecting the science of climate change to financial risk assessments
  • Time horizon – many climate risks will manifest over a longer time horizon than businesses traditionally consider
  • Complexity and uncertainty of climate risk – there is a high degree of uncertainty across the range of potential environmental and physical impacts
  • Policy and economic uncertainty surrounding future potential policy can impede progress
  • Trade-offs – between climate-related financial risk mitigation efforts and other objectives (e.g., efforts to mitigate climate risk could negatively impact objectives to promote community development in vulnerable communities); this is where there can be some friction between the “E” and the “S” in ESG

In statements supporting the FSOC report, Fed Chair Powell acknowledged that the Fed is developing a program of scenario analysis to evaluate the potential economic and financial risks posed by different climate outcomes. Acting Comptroller Mike Hsu’s statement noted that the OCC is developing high level climate risk management supervisory expectations for large banks, with the goal of releasing it by year end. 

My reading of the report and the accompanying statements from FSOC members is that many agencies are likely going to devote significant near-term attention to two efforts: (1) building expertise and capacity as it relates to climate change and (2) identifying and closing data and methodological gaps.  These two efforts should provide the groundwork to enhance public disclosure and to inform risk identification and mitigation using scenario analysis. 

Given the uncertainty, even amongst the regulators, of exactly how to approach identifying, quantifying and mitigating climate-related financial risks, forward-thinking financial institutions may have a great opportunity to help shape the direction of this inevitable regulatory scrutiny. 

But make no mistake, some type of supervisory guidance is likely coming soon.  Both the Fed and the OCC have confirmed as much. The FSOC report provides a framework for how the agencies are thinking about this issue today and their likely path forward.  

Banks should begin now to expand their thinking on climate risk as the focus widens from an investor-focused ESG or Corporate Social Responsibility lens to one that also includes identifying and mitigating climate-related financial risks.  Being mindful of the potential friction between environmental and social impacts will be important.  Building capacity and expertise from a risk management standpoint, understanding data gaps, and taking a hard look at the robustness and quality of public disclosures are all good places to start.

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