Designing a Prudential Supervisory Framework for Climate Change in the U.S.

This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here. 

 

Similar to the lead-up to the 2008 financial crisis, when the Federal Reserve (the Fed) and other federal regulators were more concerned with maintaining the flow of housing credit and pushing back against states’ attempts to curb predatory lending than they were with addressing a clear housing bubble, the Fed is currently preoccupied with propping up firms that contribute to climate change as opposed to limiting the financial sector’s exposure to an industry that threatens the country’s long-term physical and economic health. But, unlike financial markets, climate change is not cyclical. This means that it is not too late for U.S. regulators to cast aside the partisanship that has paralyzed policy action around climate change and develop a robust supervisory program to strengthen the financial sector’s resilience to climate-related risks.

Unfortunately, several recent reports reveal how out of step U.S. financial regulators are with their global peers when it comes to understanding and regulating the risks that climate change poses to financial institutions and financial stability. By examining the contents of these reports, in conjunction with best practices abroad and current initiatives within the Fed, this post attempts to provide a roadmap for U.S. prudential supervisors – principally the Fed but also the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) – to follow before it is too late.

Network for Greening the Financial System

On May 27, 2020, the Network for Greening the Financial System (NGFS) released the “Guide for Supervisors: integrating climate-related and environmental risks into prudential supervision” (the Guide). The NGFS is a group of central banks and financial institution supervisors from around the world who meet on a voluntary basis to share best practices and contribute to the development of environment and climate risk management in the financial sector. Despite prodding from some members of Congress – in May, U.S. Representatives Sean Casten (D-IL) and Mike Levin (D-CA) led a letter signed by 41 of their House colleagues calling on the Federal Reserve to join the NGFS as an active member – no U.S. federal regulatory agency has joined the NGFS as an active member nor as an observer. In fact, only one U.S. regulatory agency, the New York Department of Financial Services, is a NGFS member, even though every major central bank outside the U.S. is a member, including the Bank of England, the European Central Bank, and the People’s Bank of China.

The Guide incorporates current supervisory practices and new analysis to produce a comprehensive playbook for banking and insurance supervisors to integrate climate-related and environmental risks into their work. U.S. banking supervisors would be well served to follow the Guide’s five recommendations.

Recommendation 1 – Supervisors are recommended to determine how climate-related and environmental risks transmit to the economies and financial sectors in their jurisdictions and identify how these risks are likely to be material for the supervised entities.

Before meaningful policies are enacted, supervisors must first do the work to understand the ways that climate risks can impact their national economy and financial institutions. The financial risks from climate change fall under two categories: physical risks and transition risks. The NGFS defines physical risks as “the economic costs and financial losses resulting from the increasing severity and frequency of extreme climate change-related weather events” as well as “longer-term progressive shifts in the climate.” Transition risks impact financial institutions through the “process of adjustment towards a lower-carbon and more circular economy, prompted, for example, by changes in climate and environmental policy, technology or market sentiment.” In 2019, the NGFS published a report that identified the transmission channels through which climate change can impact the economy and the financial system, but it ultimately falls on national supervisors to understand those channels which may be more or less relevant in their jurisdiction given geographic exposures and political dynamics. Thus, it is important for central banks and supervisors to develop the institutional capacity to study and understand these risks.

Recommendation 2 – Develop a clear strategy, establish an internal organization and allocate adequate resources to address climate-related and environmental risks.

Supervisors cannot expect the institutions they oversee to measure and manage their climate risk exposures without first integrating these risks into their own work and training staff on the threat climate change poses to financial institutions and financial stability. As the Guide acknowledges, this work must start at the top, with a commitment from the supervisor’s Board of Directors or Governors, which then flows into a clear institutional strategy.

Unfortunately, this high-level commitment is lacking in the U.S. At the Federal Reserve, leadership on this issue has been assumed by the Federal Reserve Bank of San Francisco and its president, Mary Daly, who stated last year that “[C]limate change is an economic issue we can’t afford to ignore.” In November 2019, the San Francisco Fed hosted a conference titled “The Economics of Climate Change,” which brought together academics from around the world to present and discuss papers such as the “Long-Term Macroeconomic Effects of Climate Change” and “The Environmental Bias of Trade Policy.” While the conference was an important start, the papers and topics discussed focused primarily on the broader macroeconomic effects of climate change and less on the risks to individual financial institutions and financial stability.

Speaking at the conference, Federal Reserve Board Governor, Lael Brainard, acknowledged that the Fed needs to assess the financial system for vulnerabilities  to important climate risks.” However, Brainard stopped short of explaining how exactly the Fed would go about assessing these risks or who within the Fed would be responsible for such an effort.

The Federal Reserve possess a world-class economics research function and it is imperative that Fed researchers continue to publish on the economic and financial risks from climate change in order to raise awareness “internally and externally across the financial system and among the public.” But ultimately, this awareness needs to coalesce into a holistic vision that addresses climate-related risks throughout the organization. The NGFS Guide offers several models for embedding this work within the organization, specifically: networks, internal hubs, and dedicated units.

A natural starting point to address climate-related risks is for central banks and supervisors to assess how these risks impact their own organization. The Bank of England (BoE) did exactly that when they released their inaugural climate-related financial disclosure 2020 report on June 18th. The report “follows the Task Force on Climate-related Financial Disclosures’ (TCFD) framework, which is structured around four core elements: governance; strategy; risk management; and metrics and targets.”  The BoE made climate change a strategic priority in January 2020 and climate-related risks are regularly discussed at the Bank’s senior committees, thanks in part to a designated executive sponsor for climate-related risks. The report assesses the financial risks from climate change across the Bank’s entire operations, including “its physical activities (such as the production of bank notes and the carbon footprint of its buildings and travel) and its financial activities (including the asset portfolios, held for policy and other purposes).” Expect other central banks and supervisors to start disclosing their own climate-related exposures going forward.

Recommendation 3 – Identify the exposures of supervised entities that are vulnerable to climate related and environmental risks and assess the potential losses should these risks materialize.

Supervisory agencies need to conduct the difficult work of identifying and measuring the determinants of physical and transition risks in their jurisdiction. The size of these risks will depend on the structure of the country’s financial system, exposure to climate sensitive sectors, and the geographic location of collateral and physical assets. Supervisors have adopted a variety of approaches to identify and measure climate-related risks, and as the Guide notes: “more granular approaches typically require large amounts of balance sheet and climate-related data.” Precise measurement of these risks is hindered by a lack of reliable and granular data, which is why several supervisors have resorted to conducting qualitative surveys of financial institutions, whereby the institutions explain how they consider climate-related risks in their “strategy, governance, risk management, scenario analyses and disclosures.” The Guide provides an example of the type of questions supervisors may want to include in their own survey.

Understanding the financial sector’s exposure to climate-related risks takes time and resources. According to a survey of NGFS members, it takes “approximately one year and a dedicated team fully supported by senior management to produce a report on climate-related and environmental risk assessment for a financial sector from scratch.”

Risk assessment in hand, supervisors should then quantify exposures using required data sources. For instance, supervisors can assess the carbon intensity of certain portfolios by relying on sector classifications, emissions data, and asset location and tenor. Some supervisors have even begun to model different climate pathways through sensitivity analysis and stress testing. Such analysis “enables supervisors to explore the impact of different possible climate change pathways in four dimensions: financial institution-specific risks, financial system-wide risks, macroeconomic risks and risks to central banks’ own balance sheets.”

In 2017, the Dutch National Bank conducted a scenario analysis that showed “that floods with a probability between 1/200 and 1/1000 years (which is in line with norms for shocks in financial supervisory frameworks) could lead to losses ranging between EUR 20-60 billion, with at least several billions being absorbed by the balance sheets of financial institutions.” And in 2021, the BoE will use its biennial exploratory scenario to stress test the “resilience of the current business models of the largest banks, insurers and the financial system to climate related risks” and determine “the scale of adjustment that will need to be undertaken in coming decades for the system to remain resilient.”

Despite these initial attempts at climate stress testing, the practice suffers from limitations due to a lack of available data and underdeveloped and unproven methodological frameworks. To help further develop and systematize the process of climate-related financial stress testing, the NGFS recently published a set of climate scenarios as well as a guide for central banks and supervisors on how to use scenario analysis to assess climate risk to the economy and financial system. Even with these tools, it will probably be at least several years before supervisors incorporate the results of climate stress tests into prudential capital and liquidity requirements.

Recommendation 4 – Set supervisory expectations to create transparency for financial institutions regarding the supervisors’ understanding of a prudent approach to climate-related and environmental risks

The previous recommendations are intended to aid in the development of comprehensive supervisory expectations, which should cover the following five areas: governance, strategy, risk management, scenario analysis, and disclosure. The Guide notes that supervisors typically require between 8 to 12 months to develop these expectations, typically after a period of consultation with the industry and the review of public comments. Because supervisors and financial institutions tend to examine climate-related risks through established risk categories such as credit, market, liquidity, and operational risk, supervisory guidance for climate-related risks may fit within existing expectations and requirements around governance and risk management. For instance, supervisors already expect financial institutions to be aware of potential changes in their business environment and to measure and monitor exposures to all relevant risks. Several supervisors also expect financial institutions to “disclose information and metrics on the climate-related and environmental risks they are exposed to, their potential impact on the safety and soundness of the institution and how they manage those risks.”

In April 2019, the UK’s Prudential Regulation Authority (PRA) became the first supervisory agency to publish supervisory expectations for banks’ and insurers’ on approaches to managing the financial risks from climate change. This supervisory statement came on the heels of a sectoral review that revealed few firms were taking a strategic approach to climate change “that considers how actions today affect future financial risks.”

The PRA’s supervisory statement makes clear that it will embed the “measurement and monitoring of these expectations into its existing supervisory framework” and that a firm’s approach to managing the financial risks from climate change should evolve as more data and expertise become available. At a minimum, the PRA expects “a firm’s board to understand and assess the financial risks from climate change” and for climate risks to be incorporated in the firm’s risk appetite statement. Including these risks in the risk appetite statement ensures their incorporation into existing risk management frameworks, thereby forcing firms to “identify, measure, monitor, manage, and report on their exposure to these risks.” The PRA also expects firms, “where proportionate,” to conduct scenario analysis to understand the impact of the financial risks from climate change on their solvency and liquidity. Finally, while stopping short of imposing new disclosure requirements on firms, the PRA encourages firms to consider whether further disclosures on the financial risks from climate change are necessary to comply with Basel Pillar 3 requirements mandating that firms disclosure information on material risks.

In May 2020, the ECB followed the PRA’s lead when they released their guide on climate-related and environmental risks which explains how it “expects banks to safely and prudently manage climate-related and environmental risks and disclose such risks transparently under the current prudential framework.” The ECB guide is non-binding and reiterates the need for institutions to “consider climate-related and environmental risks – as drivers of established categories of prudential risks – when formulating and implementing their business strategy and governance and risk management frameworks.”

The ECB’s guide is more prescriptive than the PRA’s supervisory statement along several dimensions. For instance, the ECB expects institutions to consider climate-related risks at all stages in the credit-granting process and to identify and measure these risks as part of its internal capital adequacy assessment process. Furthermore, institutions with material climate-related risks are expected to measure capital adequacy using baseline and institution-specific adverse scenarios “in line with scientific climate change pathways.” Finally, unlike the PRA, the ECB explicitly calls on firms to “assess whether climate-related and environmental risks could have a material impact on net cash outflows or liquidity buffers.”

The NGFS Guide acknowledges that initial supervisory guidance around climate risks is “largely high-level and non-technical.” This will change over time as more and better data become available, taxonomies and methodologies are refined, and the reality of ever-increasing – in both frequency and severity – climate disasters alters the political and policy landscape. Thus, supervisors are in the early stages of an evolving approach to managing climate-related financial risks.

Unfortunately, U.S. prudential regulators have no strategy for managing climate-related risks to financial institutions and financial stability. Federal Reserve Chairman Jerome Powell acknowledged that “[T]he public has every right to expect and will expect that we will ensure that the financial system is resilient and robust against the risks of climate change,” but this sentiment has not translated into a concrete action plan.

A search of “climate change” on the Federal Reserve Board and district banks’ websites reveals very little. Based upon informal conversations I have had with select Fed staff members, it appears that supervisors, as part of their continuous monitoring function, have begun asking institutions about their current approach to climate risk management. The Fed has also established a Climate Risk Sub-Group within the System’s Risk Council, neither of which can be found on any Fed website.

Further insights into the Fed’s supervisory approach to climate-related risks were revealed in March 2020, when Kevin Stiroh, the head of the New York Fed’s supervision group, gave a speech at Harvard Business School. Stiroh discussed the range of practices that supervisors were observing at financial institutions for identifying, monitoring, and managing climate-related financial risks; observations that could only be made through a concerted effort by supervisors. According to Stiroh, boards of directors and senior management are beginning to discuss the risks posed by climate change, but few firms “have formally modified or qualified enterprise-wide risk appetite statements to acknowledge climate to date, although some are considering this.” Thus, “information flows and detailed climate reporting appear more prevalent at the management committee level rather than boards of directors.” Stiroh went on to indicate that some firms are “building climate risk assessments into sectoral or industry reviews” to measure exposures in lending and trading positions – “[E]xamples include: heightened monitoring of mortgage concentrations in high-risk areas, modified risk limits or reduced tenors for transactions to certain carbon-intensive sectors, and consideration of climate risk disclosures in offering documents.” Firms are also in the early stages of conducting limited sensitivity analysis, such as stressing mortgage portfolios in specific locations.

The speech was illuminating because it was the first time anyone from a U.S. regulatory agency offered details on how large financial institutions are currently thinking about, and managing, climate-related financial risks. It was also disappointing because Stiroh prescribed a very limited role for bank supervisors when it comes to climate change. He acknowledged that supervisors should identify and manage the microprudential and macroprudential risks “that emerge along a transition path to a more sustainable economy,” but should refrain from advocating or sustaining a particular policy outcome.

Stiroh’s hesitancy to go beyond bank supervisor’s existing risk management mandate without explicit authorization and guidance is understandable and indicative of the need for a coordinated supervisory strategy that only the Fed’s Board of Governors can provide. If such a strategy is not forthcoming, it may require an act of Congress.

Recommendation 5 – Ensure adequate management of climate-related and environmental risks by financial institutions and take mitigating action where appropriate.

Once supervisory expectations are in place, supervisors must utilize the tools at their disposal to ensure firms abide by them. Under the Basel Pillar 2 supervisory review process, supervisors are empowered to require banks to hold additional capital beyond regulatory minimums to support all the risks in their business. However, current quantification challenges means supervisors have “not yet imposed (additional) capital or solvency requirements specifically linked to climate related and environmental risks.”

Supervisors can leverage the supervisory review process and requirements around existing risk categories (credit, market, liquidity, and operational risk) to impose a variety of qualitative measures on firms if they “insufficiently integrate climate-related and environmental risks into their strategy, governance, risk management, or disclosure frameworks.” According to the NGFS Guide, these measures include: discussing findings with boards of directors and requiring board follow-up, requiring strengthened risks management and internal controls, requiring firms to integrate climate-related risks into their internal capital adequacy assessment process, forcing institutions to reduce the level of risk, and limiting the distribution of profits.

Should the Federal Reserve ever establish climate-related supervisory guidance, current trends in supervision would make holding firms accountable to these expectations a challenge. In a January 2020 speech, Federal Reserve Vice Chair for Supervision, Randal Quarles, recommended sweeping changes to the nature of bank supervision, including: (1) publishing the internal procedural materials that the Fed uses to supervise large firms; (2) putting supervisory guidance out for public comment; and (3) adopting a rule clarifying how the Fed uses supervisory guidance (Quarles recommends that such a rule should confirm that guidance is not binding and “non-compliance” with guidance may not form the basis for an enforcement action). These changes would deprive examiners of their principle tool, Matters Requiring Attention (MRAs), for ensuring that firms comply with supervisory expectations. In fact, Quarles wants to limit “future MRAs to violations of law, violations of regulation, and material safety and soundness issues.”

Given these sentiments, the most effective method to get financial institutions to incorporate climate-related risks into their governance and risk management frameworks is a Congressional mandate requiring the Fed to establish a rule that would do so.

Conclusion

History has repeatedly reminded us – and is currently reminding us with the pandemic – that the next economic crisis will not look like any that have come before. Yet, with climate change, never have the warning signs been clearer. With each passing month of inaction, the Federal Reserve and other prudential regulators allow unknown climate-related risks to accumulate on bank balance sheets and threaten financial stability. The playbook exists – there are no excuses for delay.

The BoE, ECB, and NGFS have all provided a template for incorporating climate-related risks into bank supervision. In addition, the sustainability nonprofit, Ceres, recently published a report that includes more than fifty recommendations for U.S. financial regulators to adopt, including the Fed, OCC, and FDIC.

Failure to act soon will undoubtedly harm U.S. regulators’ reputations when the inevitable climate catastrophe strikes and threatens to bring down one or more large financial institutions. For the rest of us, the harm will be much greater than our reputations.

 

Lee Reiners is a Lecturing Fellow at Duke University School of Law and the Executive Director of Duke Law’s Global Financial Markets Center.

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