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Banking Regulators Take Critical Steps to Account for Climate-Related Financial Risks

By Stephanie Jones

(This piece was co-authored by Bridget Pals at NYU Law School’s Institute for Policy Integrity. It is also posted on the Institute for Policy Integrity’s website)

This fall, following a summer when climate change fueled catastrophic heat waves, droughts, floods, and fires, key U.S. authorities acknowledged the urgent need to act on climate risks to the banking system. Recent actions and remarks are beginning to shed light on what the next wave of policies to address these risks might entail. They’re likely to look a lot like many other, existing financial risk regulations.

The heads of the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) both delivered remarks highlighting actions their agencies have already taken to address climate-related banking risks and identifying additional steps they will take. Michael Barr, the Vice Chair for Supervision of the Federal Reserve (Fed), similarly stated that climate-related financial risks implicate the Fed’s “supervisory responsibilities and [its] role in promoting a safe and stable financial system,” so the Fed plans to issue guidance in coordination with fellow financial regulators and conduct scenario analyses.

The officials’ recent statements build on earlier actions by the OCC and FDIC, which both issued draft principles in the last year on how banks should manage climate risk to meet safety and soundness expectations. The Institute for Policy Integrity and Environmental Defense Fund submitted joint comments supporting both guidance documents as important steps toward addressing the risks that climate change poses to the structural integrity of our financial system.

THE BASICS OF BANKING REGULATION

In order to understand what banking regulators are doing on climate risk — and why — it’s worth starting at the beginning. To put it simply, banks give customers a safe place to hold their savings and then lend that money to provide capital people need to buy homes, start businesses, or engage in other activities that might require upfront investment. The bank then pays back interest to the deposit-holder as an incentive to keep money in the bank.

Banks lose money when loans aren’t repaid and the collateral isn’t enough to cover the balance on the loan. In order to prevent the collapse of an individual bank or the banking system as a whole, we rely upon a regulatory system that makes sure that, even if a borrower cannot repay a loan, a bank will have enough money on hand to pay out its depositors. This is where banking regulators come in. In addition to setting formal capital requirements — which prescribe how many liquid assets a bank needs to keep available — regulators develop guidance that advises banks on how they can operate in a manner consistent with basic principles of safety and soundness.

To determine whether a bank is operating in a safe and sound manner, regulators consider a variety of risk management practices. For example, they inspect whether a bank has robust underwriting practices — how does it determine likelihood of a borrower paying back a loan? — and whether it securitizes its loans with sufficient collateral. Regulators also consider whether a bank has sufficient liquidity, assess its exposure to market volatility, and evaluate the magnitude of operational, legal, or compliance risk it might face.

A FAMILIAR STORY FOR REGULATORS

The consequences of climate change are, as Acting OCC Comptroller Michael Hsu puts it, a “bread-and-butter” financial risk, no different than other financial risks that a bank’s portfolio might face. Climate-related financial risks — such as damages associated with increasing wildfires, extreme heat, or flooding — are significant and increasing. The U.S. recorded an unprecedented 42 high-cost extreme weather events in the last two years alone, with each event individually resulting in at least $1 billion in direct damages. In addition, these risks may also affect health and safety, crop production, housing, labor productivity, and more. These types of risks permeate the economy and may have profound impacts on how banks should manage their business operations.

Climate-related financial risk is right in line with the types of risks that U.S. banking regulators already oversee, and they already expect banks to ask themselves many relevant risk-assessment questions. How valuable is the collateral? Will it retain that value? How creditworthy is the borrower? Does the bank have enough assets that can be liquidated without losing value, in the event the bank needs ready access to cash? What types of events could interrupt bank operations? Are the bank’s actions creating litigation risk? Still, although the core questions remain the same, there is immense value in focusing on how climate-related risks may affect the answers. The recent efforts and announcements by the Federal Reserve, OCC, and FDIC represent a strong first step in the right direction to ensure banks build up the proper data, expertise, and processes to manage climate-related risks.

AN EYE ON INEQUITY

As we noted in our comment letters, banking regulators should also ensure that approaches to address climate-related financial risk do not exacerbate inequities. Due to redlining and other discriminatory practices, communities of color have been pushed into more climate-risky areas. Systemic underinvestment in infrastructure has compounded the problem, placing low-income communities and communities of color on the frontlines of climate change. If banks try to avoid climate-risky loans, they could end up reducing credit access in areas that are already overburdened and undercapitalized. Banking regulators should remind banks of their obligations to ensure fair access to credit, listen to the expertise and priorities of affected communities, and coordinate with other relevant agencies to ensure the costs of transition are borne equitably.

The banking system conducts complicated exercises in risk management every day. As with any other major risk category, banks need to weigh how climate change may affect their business. Americans’ financial security depends on the OCC, FDIC, Federal Reserve, and other regulators ensuring that banks satisfy their classic obligations of safety and soundness under the new climate circumstances we face.

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