Risk management is a critical concern for both banks and the regulators who oversee them. Banks take a variety of risks in the course of their business activities. Credit risk can arise, for example, when a bank extends loans to borrowers who are unable to repay their loans, and liquidity risk can arise when a bank is forced to sell assets at a significant loss to meet its debt obligations – for example, when there is a run into the bank and they don’t have the cash that depositors are asking for. Although risk management is important for banks to protect against losses and insolvencies, it is also a major public policy concern; The fact that the state insures bank deposits and that the failure of a single institution can have systemic repercussions requires an active role for regulators.
One area where banking regulators need to act is in dealing with climate-related financial risks – those risks that arise from the consequences of a warming planet. In particular, climate change can create physical risks, as extreme weather and other climate events cause losses in financial assets, and transition risks, as government policies, private policies and business practices change to adapt to a low-carbon economy. These risks are so serious that the Financial Stability Oversight Council has identified climate change as an “emerging threat to financial stability.”
Climate change threatens not only the well-being of the environment, but also of financial markets and institutions.
Banks’ central role in the economy exposes them to these risks in a way that requires prudent management, and in recognition of this fact, the Federal Deposit Insurance Corporation (FDIC) recently issued a proposal for policies governing large banks under its supervision to identify and address climate-related risks for their companies. The FDIC’s proposal closely follows a similar document issued by the Office of the Comptroller of the Currency (OCC) last December.
If finalized, the principles proposed by the FDIC — and OCC — would represent a positive step forward in ensuring banks recognize the risks that climate change poses to their businesses and take concrete action to mitigate those risks deal with. The proposed principles describe how banks should integrate climate risk management into various aspects of their business, including corporate governance (ie board and officers), policies and procedures, strategic planning and risk management. They also urge banks to engage in scenario analysis that would examine their institutions’ vulnerability to a variety of potential climate-related events. These measures are critical for banks of all sizes to take proactive risk mitigation actions before the problem becomes even more serious.
Additionally, the FDIC made it appropriately clear that its focus on climate-related financial risks is about security and soundness concerns, writing, “Weaknesses in identifying, measuring, monitoring, and controlling the physical and transitional risks associated with a changing climate could adversely affect the safety and health of a financial institution and the overall financial system.” Because the safety and health of banks is critical not only to their customers but to the overall financial system and economy, the FDIC has extensive regulatory and regulators to ensure banks are taking steps to protect their operations and balance sheets.
When financial markets and institutions fail, it is usually the least affluent in society who suffer most from the resulting economic fallout.
In a letter of comment to the FDIC on its proposed principles, the Center for American Progress offered the following recommendations for the FDIC to consider in finalizing its guidance and issuing future climate-related guidance documents:
- Given that all banks are exposed to climate-related financial risks, the FDIC’s principles must be high enough to apply to all banks, not just banks with assets over $100 billion. Implementation of the Principles, both through guidance and through audits, can be tailored to a bank’s size and businesses, but all banks should follow the Core Principles.
- The FDIC must explain to banks how climate risks are interconnected and relate to traditional financial risks, while providing guidance on how climate-related financial risks fit into the framework used by auditors to rate banks—known as CAMELS.
- The FDIC must require banks to meet their public commitments related to climate, specifically around net-zero promises and the use of carbon offsets.
- The FDIC should issue guidance related to the impact of climate risk mitigation on low- and middle-income (LMI) communities, including detailing how institutions can continue to lend to vulnerable communities in a safe and sound manner; Working with the other federal bank agencies to update their Community Reinvestment Act (CRA) rules to ensure credit is flowing to LMI and other disadvantaged communities to help them reduce their fossil fuel emissions and protect themselves from climate impacts; and ensure that banks assess whether their efforts to mitigate climate risk are having a fair impact on lending.
- The FDIC should work with the OCC and the Federal Reserve Board to amend their call reports and any other required reports to include relevant fields related to banks’ climate-related financial risks.
- The FDIC must begin conducting scenario analysis quickly, even if the initial scenarios are somewhat simplistic. In addition, it must provide banks with multiple scenarios describing orderly and disorderly transitions and ensure that banks’ models are sufficiently rigorous and avoid obvious pitfalls such as model shopping. Both large and regional banks should participate in scenario analysis.
Climate change threatens not only the well-being of the environment, but also of financial markets and institutions. And when financial markets and institutions fail, it is usually the least affluent in society who suffer most from the resulting economic fallout. Accordingly, the FDIC and other banking regulators — including the Federal Reserve, which should also issue similar guidance to the banks and bank holding companies it regulates — must act urgently to ensure banks are aware of the risks that climate change poses to their businesses and take plausible measures to mitigate these risks.