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Dec 8 2021

Bank Regulators Respond to Climate Risks

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Alicia R. Karspeck, PhD

Head of Research

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Financial regulators respond to Biden's executive order calling for agency action toward managing climate risk

 

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Last month, Michael Hsu, the Acting Comptroller of the Currency gave a speech at OCC headquarters proposing a five point framework for national banks to assess their readiness for the policy, regulatory, and physical risks of climate change. 

The Office of the Comptroller of the Currency (OCC) is a bureau of the U.S. Department of the Treasury that (among other things) regulates and supervises national and foreign banks operating in the U.S.  Supervision within the U.S. commercial banking system is admittedly convoluted, with the Federal Reserve, the FDIC, and the OCC parsing authority over different types of commercial banks) 

The speech sent (minor) tremors through the retail banking industry – as the regulatory burden of the reporting, if formalized, would be substantial.  The framework takes the form of five questions that bank boards should ask their management as they consider their climate risk: 

Question 1:   “What is our overall risk exposure to climate change?”   Right to the point. But the simplicity of the question downplays the enormity of the task.  For which Hsu offers two tips:  a) scenario analysis and b) “posing this question… directly and repeatedly to senior managers” to compel them to action.  Well yes, persistence is effective.

Question 2:   “Which counter-parties, sectors, or locales warrant our heightened attention and focus?”  This is where the finger-pointing gets real – and where the cost of credit is likely to increase. Of particular concern: a simultaneous deterioration in borrowers’ ability to repay and in the value of their collateral.  (Think homeowners in a wildfire-prone area, small retail business without flood insurance).

Question #3:   “How exposed are we to a carbon tax?”   This one is interesting, as it’s not immediately obvious how this impacts banks. But, as Hsu points out, it forces the bank to take a hard look at whether they have an under-appreciated concentration in carbon-intensive sectors.  

Question #4:   “How vulnerable are our data centers and other critical services to extreme weather?”   A really good question.  It’s easy to imagine that banks need only be concerned with counter-party/credit risk.  But because banking operations are critical to the wellbeing of communities and economies, banks actually have a regulatory responsibility to mitigate the risk of interruptions to their operations.  Extreme weather and flooding associated with a changing climate may increase the potential for damage to the physical infrastructure of banking (data centers, brick and mortar branches, ATMs, etc.)  Business continuity plans may need to be adjusted to account for the enhanced risk.

Question #5:   “What can we do to position ourselves to seize opportunities from climate change?   And… the silver lining.  As Hsu states: "Renewables, carbon capture, electric vehicles, charging stations…  are the most obvious banking opportunities arising from climate change.”  Hsu's suggestion is that climate risk-management as a whole will enable profitable risk-taking in regard to new business opportunities.

Most folks think it’s unlikely that these points will form the basis of  standalone regulatory requirements.  Congress has the authority to repeal federal agency regulation that it deems too aggressive, which disincentivizes the creation of a distinct rule that might become the target of scrutiny. But the 2022 OCC Supervision Plan explicitly calls out “climate change risk management” as a priority, so there’s little doubt that these ideas will find their way into the guidelines used for the  examination and supervision of national banks. 

What is the broader context of the OCC climate speech?

The move by the OCC was not unexpected.  The FSOC (Financial Stability Oversight Council), released a report in October identifying climate change as an emerging and increasing threat to U.S. financial stability, calling on member agencies to incorporate 35 recommendations for developing or enhancing their climate-risk management practices. (The FSOC comprises the heads of the US financial regulatory agencies, including the Fed, the Treasury, the OCC, the SEC, the FDIC, and more). The report came in response to President Biden’s May executive order calling for a whole-of-government approach to managing climate risk.  

The November speech by the OCC naturally raised questions about the stance of the Federal Reserve and the FDIC (which, as noted above, share responsibility for banking supervision). In testimony before the House Financial Services Committee in early December,  Jerome Powell signaled that the Fed would work toward consistency in regulator approaches, but not yet: “I don’t think we’ll be in a position to join [the OCC’s] guidance at this time, but we’ll get there.”  

The FDIC has similarly shown restraint.  Jelena McWilliams, chair of the FDIC, went as far as to abstain from the vote to approve a FSOC climate report, saying that it lacked sufficient “analysis, evidence and recognition of how banks and regulators have handled the issue thus far.”   According to McWilliams, the banks that the FDIC works with are well-aware of the climate risk-profile of their borrowers, as well as how robust its collateral is to extreme weather. In a public statement, she expressed her concern that the timeline for completing the FSOC report was too tight to allow for adequate research into the impact of its recommendations. That said, she noted that the FDIC would “continue to work with the FSOC and our fellow regulators on these crucial issues.” 

What does this mean for advisors? 

Directly, nothing. But indirectly, it portends a wave of securities repricing as banks and credit agencies wake up to climate-risks –  potentially altering the terms of debt and loan financing.   Worth following for the savvy advisor.

 

Alicia Karspeck has a Ph.D. from Columbia University in climate modeling and has worked at the National Canter for Atmospheric Research for over 12 years, and a Co-Founder at SK Analytics. She is focusing on bringing climate-ESG and financial-factor insights to risk management practices for long-term investors.