Federal banking regulators issue principles for climate-related financial risk management
In an effort to help large financial institutions – those with $100 billion or more in total assets – address climate-related financial risks, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (the Fed), and the Federal Deposit Insurance Corporation (FDIC) have jointly issued Principles for Climate-Related Financial Risk Management for Large Financial Institutions.
Federal banking agencies contend that “the economic effects of climate change and the transition to a lower carbon economy pose an emerging risk to the safety and soundness of financial institutions and the financial stability of the United States.” The Principles are intended to “provide a high-level framework for the safe and sound management of exposures to client-related financial risks, consistent with the risk management frameworks described in the agencies’ existing rules and guidance.”
Rather than offering a one-size-fits-all approach, the regulators set out general climate-related financial risk management principles for financial institutions to consider in six areas: governance; policies, procedures, and limits; strategic planning; risk management; data, risk measurement, and reporting; and scenario analysis.
Below, we take a concise look at each area.
Governance. The Principles state that the boards of large financial institutions should understand the potential effects of climate-related financial risks. To ensure that this is accomplished, boards should instruct their management to provide accurate and timely information, thus enabling them to effectively perform this part of their oversight role. Further, the Principles advise boards to obtain “sufficient information to understand the implications of climate-related financial risks across various scenarios and planning horizons, which may include those that extend beyond the financial institution’s typical strategic planning horizon.”
Policies, procedures, and limits. The Principles instruct that management of large financial institutions should incorporate climate-related financial risks into a firm’s policies, procedures, and limits. Further, these policies, procedures, and limits should be modified to reflect the “distinctive characteristics of climate-related financial risks, such as the potentially longer time horizon and forward-looking nature of the risks” and changes to a firm’s activities or operating environment.
Strategic planning. As part of a firm’s forward-looking strategic planning, the banking regulators advise the firm’s board and management to consider the potential impact of material climate-related financial risk exposures on overall condition, operations, and objectives “over various time horizons.” According to the Principles, the board should encourage management to evaluate how the institution’s strategies for mitigating climate-related financial risks affect low- and-moderate-income and other underserved consumers and communities, particularly in terms of their access to financial products and services. Further, boards and management are reminded that they should ensure that any public statements about their climate-related strategies and commitments are consistent with their internal strategies, risk appetite statements, and risk management frameworks. The Principles recognize that “the incorporation of material climate-related financial risks into various planning processes will be iterative, as measurement methodologies, models, and data for analyzing these risks continue to mature.”
Risk management. Management is also advised to oversee the development of comprehensive “processes to identify, measure, monitor, and control exposures to climate-related financial risks.” The risk identification process should be based on input from stakeholders across the organization with relevant expertise and include an assessment of climate-related financial risks “across a range of plausible scenarios and under various time horizons.” Material climate-related financial risk exposures should be clearly defined and supported by appropriate metrics. The agencies suggest that “[t]ools and approaches for measuring and monitoring exposures to climate-related financial risks include, among others, exposure analysis, heat maps, climate risk dashboards, and scenario analysis.”
Data, risk measurement, and reporting. The Principles provide that management should incorporate climate-related financial risk information into the financial institution’s internal reporting, monitoring, and escalation processes. Risk data aggregation and reporting capabilities should allow management to capture and report climate-related financial risk exposures, segmented or stratified by physical and transition risks.
Scenario analysis. The Principles advise management to create an effective climate-related scenario analysis framework. Management should develop these climate-related scenario analyses in a manner commensurate to the financial institution’s size, complexity, business activity, and risk profile. These frameworks should include clearly defined objectives that reflect the financial institution’s overall climate-related financial risk management strategies, and such analyses should be subject to management oversight, validation, and quality control standards commensurate to the financial institution’s risk.
Additionally, the Principles describe how climate-related financial risks can be addressed in the supervision of traditional risk areas, including credit, market, liquidity, operational, and legal risks. For example, the document suggests that management should consider climate-related financial risks as part of the underwriting process and ongoing monitoring of portfolios.
Likewise, the Principles state that management should assess whether climate-related financial risks could affect a firm’s liquidity position and, if so, incorporate those risks into their liquidity risk management practices and liquidity buffers.
In summary
Although regulators already expect financial institutions to prudently manage risk, the federal banking agencies’ Principles mark an important step forward, providing guidance to the largest banking institutions on addressing climate-related risks. How aggressively the guidance will be applied by banking examiners remains to be seen.
The interagency guidance clarifies that large financial institutions are neither forbidden nor discouraged from providing services to any specific class or type of customers. The institutions themselves have the discretion to decide on loan issuance and the management of accounts. However, the Principles do encourage financial institutions to assess the climate-related financial risks associated with their customer relationships.
Whether the Principles will ultimately encourage large financial institutions to shy away from banking relationships with the fossil fuel industry also remains uncertain.
Finally, and perhaps most importantly, the Principles are a stark reminder that large financial institutions (like all public companies) must consider incorporating environmental, social, and governance (ESG) matters and risk into their overall business and strategic planning.
DLA Piper has significant experience in ESG matters, governmental inquiries, investigations, and enforcement and is available to help companies address complex ESG and regulatory issues. If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact any of the authors or your relationship attorneys.
