I was pleased to hear that the Federal Reserve will run a pilot program next year requiring the United States’ most globally systemically important banks (GSIBs) to run climate change scenarios. This is a step in the right direction, since the safety and soundness of banks is critical to the development of our country. At the end of 2020, I wrote All U.S. Bank Regulators Should Require Banks To Incorporate Climate Change Risks into Their Risk Management Frameworks and Disclosures, precisely because banks can suffer significant financial losses from climate-change related physical and transition risks.
According to the Federal Reserve’s press release earlier this week, “by considering a range of possible future climate pathways and associated economic and financial developments, scenario analysis can assist firms and supervisors in understanding how climate-related financial risks may manifest and differ from historical experience. The banks in the pilot exercise are Bank of America
The Federal Reserve, as well as the other two national bank regulators, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), should be requiring a lot more from these six banks, especially since there are already guidance, principals, and/or stress tests designed by the Financial Stability Board (FSB), the Network of Central Banks and Supervisors for Greening of the Financial System (NGFS), the Basel Committee for Banking Supervision (BCBS), the New York Department of Financial Services (NYDFS), the Bank of England (BoE) and the European Central Bank (ECB). Moreover, regulators should be thinking of climate change requirements for regional and community banks, because hundreds of these banks are in municipalities adversely affected not only by droughts and fires, but also by rising sea levels, hurricanes and inland river floods.
While the pilot program that the Federal Reserve will run next year is likely to yield interesting data and gaps with climate change modeling, that can be very useful in informing future climate change supervisory exercises and requirements, there is no reason to wait until 2024 and beyond. I believe banks will need clear rules or guidance on how to incorporate climate change risks into their risk management frameworks, including quarterly and annual portfolio and enterprise-wide stress tests. Yet, banks do not have to wait for rules or guidance to be formalized. The vast majority of banks in the Unites States have been required for almost years to comply with Basel III capital, liquidity, and leverage requirements introduced as rules by our bank regulators here. Under Basel III’s Pillar I, there is a requirement and guidance for banks to measure their operational risks. Operational risk is a threat to a bank’s earnings due to problems with people, process, technology, and externa events. External events is precisely where measuring the impact of climate change fits in. Banks can include extreme weather and natural disaster events in their analysis of operational risk.
Additionally, climate change-related risks can be already be included in Basel III’s Pillar II which has guidance for enterprise wide and portfolio stress tests. Pillar II is not prescriptive; it is principals based. Hence, banks have flexibility in designing models that are tailored to the specific climate change risks that they are encountering, rather than using models that have to conform to regulatory requirements, which by their very nature are one-size-fits-all. Banks can incorporate climate-change related risks in their models to evaluate the impact on their credit portfolios (i.e. mortgages, retail, commercial, and syndicated loans). Since climate change risks can also adversely impact banks’ trading portfolios (stock, fixed income, commodity and foreign exchange), banks already can include asset price stresses into their Value-at-Risk and Expect Shortfall models.
Importantly, this summer the Basel Committee for Banking Supervision, the most important global, standard setter for banks, published “Principles for the effective management and supervision of climate-related financial risks.” U.S. bank regulators, and others for that matter, now have very important principles that they can require their banks to adhere to. The BCBS designed18 high-level principles. Principles 1 through 12 provide banks with guidance on effective management of climate-related financial risks; principles 13 through 18 provide guidance for prudential supervisors. According to the BCBS, “the principles seek to achieve a balance in improving practices related to the management of climate-related financial risks and providing a common baseline for internationally active banks and supervisors, while maintaining sufficient flexibility given the degree of heterogeneity and evolving practices in this area.” Nothing stops U.S. bank regulators from requiring globally systemically important banks and regional ones from implementing these principles.
Principles for the effective management and supervision of climate-related financial risks
Principle 1: Banks should develop and implement a sound process for understanding and assessing the potential impacts of climate-related risk drivers on their businesses and on the environments in which they operate. Banks should consider material climate-related financial risks that could materialise over various time horizons and incorporate these risks into their overall business strategies and risk management frameworks.
Principle 2: The board and senior management should clearly assign climate-related responsibilities to members and/or committees and exercise effective oversight of climate-related financial risks. Further, the board and senior management should identify responsibilities for climate-related risk management throughout the organisational structure.
Principle 3: Banks should adopt appropriate policies, procedures and controls that are implemented across the entire organisation to ensure effective management of climate-related financial risks.
Internal control framework
Principle 4: Banks should incorporate climate-related financial risks into their internal control frameworks across the three lines of defence to ensure sound, comprehensive and effective identification, measurement and mitigation of material climate-related financial risks.
Capital and liquidity adequacy
Principle 5: Banks should identify and quantify climate-related financial risks and incorporate those assessed as material over relevant time horizons into their internal capital and liquidity adequacy assessment processes, including their stress testing programmes6 where appropriate.
Risk management process
Principle 6: Banks should identify, monitor and manage all climate-related financial risks that could materially impair their financial condition, including their capital resources and liquidity positions. Banks should ensure that their risk appetite and risk management frameworks consider all material climate-related financial risks to which they are exposed and establish a reliable approach to identifying, measuring, monitoring and managing those risks.
Principle 7: Risk data aggregation capabilities and internal risk reporting practices should account for climate-related financial risks. Banks should seek to ensure that their internal reporting systems are capable of monitoring material climate-related financial risks and producing timely information to ensure effective board and senior management decision-making.
Comprehensive management of credit risk
Principle 8: Banks should understand the impact of climate-related risk drivers on their credit risk profiles and ensure that credit risk management systems and processes consider material climate-related financial risks.
Comprehensive management of market, liquidity, operational and other risks
Principle 9: Banks should understand the impact of climate-related risk drivers on their market risk positions and ensure that market risk management systems and processes consider material climate-related financial risks.
Principle 10: Banks should understand the impact of climate-related risk drivers on their liquidity risk profiles and ensure that liquidity risk management systems and processes consider material climate-related financial risks.
Principle 11: Banks should understand the impact of climate-related risk drivers on their operational risk8 and ensure that risk management systems and processes consider material climate-related risks. Banks should also understand the impact of climate-related risk drivers on other risks9 and put in place adequate measures to account for these risks where material. This includes climate-related risk drivers that might lead to increasing strategic, reputational, and regulatory compliance risk, as well as liability costs associated with climate-sensitive investments and businesses.
Principle 12: Where appropriate, banks should make use of scenario analysis10 to assess the resilience of their business models and strategies to a range of plausible climate-related pathways and determine the impact of climate-related risk drivers on their overall risk profile. These analyses should consider physical and transition risks as drivers of credit, market, operational and liquidity risks over a range of relevant time horizons.
Prudential regulatory and supervisory requirements for banks
Principle 13: Supervisors should determine that banks’ incorporation of material climate-related financial risks into their business strategies, corporate governance and internal control frameworks is sound and comprehensive.
Principle 14: Supervisors should determine that banks can adequately identify, monitor and manage all material climate-related financial risks as part of their assessments of banks’ risk appetite and risk management frameworks.
Principle 15: Supervisors should determine the extent to which banks regularly identify and assess the impact of climate-related risk drivers on their risk profile and ensure that material climate-related financial risks are adequately considered in their management of credit, market, liquidity, operational, and other types of risk. Supervisors should determine that, where appropriate, banks apply climate scenario analysis.
Responsibilities, powers and functions of supervisors
Principle 16: In conducting supervisory assessments of banks’ management of climate-related financial risks, supervisors should utilise an appropriate range of techniques and tools and adopt adequate follow-up measures in case of material misalignment with supervisory expectations.
Principle 17: Supervisors should ensure that they have adequate resources and capacity to effectively assess banks’ management of climate-related financial risks.
Principle 18: Supervisors should consider using climate-related risk scenario analysis to identify relevant risk factors, size portfolio exposures, identify data gaps and inform the adequacy of risk management approaches. Supervisors may also consider the use of climate-related stress testing to evaluate a firm’s financial position under severe but plausible scenarios.
In addition to implementing these Basel principles, bank regulators should update examiner supervisory manuals to incorporate clear guidance for examiners to evaluate whether banks are beginning to incorporate climate change risks as part of their operational risk management and as part of their Basel Pillar II portfolio and enterprise-wide stress testing. While specific climate change guidance does not exist yet in Federal Reserve supervisory manuals such as the Bank Holding Company (BHC) Supervision Manual, there are already ways that Federal Reserve examiners can begin looking to see how banks analyze the impact of climate risks on their loan and trading portfolios. For example, there is guidance for examiners to analyze how banks define, identify, measure, control and monitor their operational risks. At the very least, bank examiners can and should ask banks to provide examples of how much they have lost in their credit or market portfolios when there have been natural disasters or extreme weather events.
Not only is it important for banks to incorporate climate change risks into their risk management frameworks, they should disclose their risks to the public, both in their financial disclosures to the Securities and Exchange Commission and in their Basel III, Pillar III risk disclosures. U.S. bank regulators and banks would certainly benefit from looking at the Financial Stability Board’s Task Force on Climate-related Financial Disclosures. Just this April, the National Association of Insurance Commissioners voted to require insurance companies in the U.S. to disclose their climate change exposures using the Task Force on Climate-related Financial Disclosures. Given how interconnected banks are to every type of financial institution, corporation, municipality, and ordinary Americans, there is no reason that banks shouldn’t at least follow the TCFD format. Until there are robust climate change measurement and disclosures required from banks, lenders to and investors in banks are operating with incomplete information. Caveat emptor!
Other Articles By This Author About Climate Change And Operational Risk
The Financial Stability Board’s Climate-Change Road Map Identifies Data Gaps That Need To Be Addressed
Rodríguez Valladares Testified On Climate as a Systemic Risk To The Financial System
Rodríguez Valladares Testifies On Climate Change And Financial Systemic Risk
All U.S. Bank Regulators Should Require Banks To Incorporate Climate Change Risks into Their Risk Management Frameworks and Disclosures
Banks Can Suffer Financial Losses From Physical And Transition Climate Change Risk Drivers
Banks Should Implement Principles For Operational Resilience
Climate Change Is A Key Priority To The G20 And Financial Stability Board
Climate Change Risks Should Be A Priority For U.S. Bank Supervisors
Ignoring Climate Related Physical And Transition Risks Imperil Global Financial Stability
Rising Sea Levels Pose Increasing Credit Risks for Many U.S. Coastal States and Investors in their Bonds
Operational Risk Ignored More Than A Bridesmaid