On October 24, 2023, the Federal Reserve (Fed), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) jointly issued comprehensive guidance on climate-related financial risk management for large institutions. This guidance had been eagerly awaited for nearly two years, having initially been published by the OCC in December 2021, with other agencies following suit in 2022. The release was accompanied by statements from the Fed Chairman, several Fed Governors, and several other agency directors. This development holds significance not only for institutions subject to the guidance but also for others in the financial sector seeking insights. This article delves into the key aspects of the guidance, the ongoing debate surrounding it, and what non-covered institutions should consider regarding climate risk management.
Interagency Guidance Overview
The guidance primarily emphasizes the mitigation and management of climate-related financial risks, encompassing both physical and transition risks. As specified in a Fed Staff’s September 25, 2023 Board Memorandum, these risks can manifest as traditional micro-prudential risks, including credit, market, liquidity, operational, and legal risks.
The final guidance offers clarifications, particularly regarding the roles of boards and management. It outlines expectations and responsibilities, aligning with existing interagency guidance on board effectiveness and governance. Notably, the guidance excludes discussions on compensation practices, as the agencies believe this matter is adequately addressed in current interagency guidance. Furthermore, the guidance expands its reach to include foreign banking institutions with combined US operations exceeding $100 billion.
The principles outlined in the guidance are designed to enable financial institutions to better manage climate-related financial risks within the framework of sound and secure practices.
Objectives for Financial Institutions
The guidance presents potential objectives aimed at enhancing the assessment of climate-related financial risks. These include exploring the impact of such risks on a financial institution’s strategy and business model, identifying vulnerabilities to climate-related financial risk factors, estimating exposures and potential losses under various scenarios, recognizing data and methodological limitations, and informing management’s assessment of the adequacy of the risk management framework. These assessments are conducted with a focus on traditional risk management aspects, encompassing credit, liquidity, market, operational, legal, and compliance risks.
Ongoing Debate and Future Focus
While the guidance was jointly issued with strong support from agency leaders, some Federal Reserve governors expressed dissenting views. Governors Michelle Bowman and Christopher Waller raised concerns about the guidance, citing unclear expectations, unintended consequences, and skepticism regarding long-range horizon scenario analysis.
However, other regulators voiced opinions that the principles do not go far enough and that further rules and guidance will follow. They emphasized the need to address emerging risks, including climate-related financial risks, with a sense of urgency. The Consumer Financial Protection Bureau (CFPB) Director Rohit Chopra, in particular, stressed the importance of banks adapting to changing financing needs and serving communities during times of stress or after catastrophic events. He called for future guidance and rules to be clear and concise where appropriate.
Risk Management Takeaways for Non-Covered Institutions
- Digest the Guidance: Stay informed about evolving climate-risk guidelines. Governments, regulators, and organizations worldwide are developing a myriad of new rules and approaches related to climate risk management.
- Be Proactive: While you may not be currently subject to these guidelines, there’s a possibility that they will impact your institution in the future. Engage in proactive dialogue with key stakeholders to prepare for potential changes and shape your institution’s risk management approach.
- Analyze Your Risk Profile: Assess how climate-related financial risks could affect your institution’s strategy and success. Examine your vulnerability to such risks, both in terms of transition and physical risk.
- Assess Your Messaging and Information Systems: Ensure that the messaging provided by your institution aligns with your environmental, social, and governance (ESG) commitments. Validate that your data and reporting systems support your goals.
- Embed Climate Risk Consideration: Encourage discussions about climate-related financial risks within your institution’s compliance and risk management teams. Foster a bottom-up approach in identifying and addressing potential risks and initiatives.
The guidance, though initially aimed at large institutions, indicates an increasing focus on climate risk management across the financial sector. Smaller institutions may also encounter these principles in due course. With regulators emphasizing the urgency of addressing climate-related financial risks, institutions of all profiles should anticipate future developments in this space.
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