The Federal Deposit Insurance Corporation (FDIC) recently published a notice of proposed policy statement related to what have been deemed “climate-related financial risks.” The FDIC is requesting comments on a set of draft principles which they feel provide a high-level overview of the safe and sound management of climate-related financial risks. Although these draft principles are targeted at the largest financial institutions, meaning those with over $100 billion in assets, all financial institutions no matter the asset size, could have exposures to climate-related financial risks and could benefit from the draft principles. These principles are intended to aid financial institutions in focusing on the management of climate-related financial risks. The comment period for this proposed policy statement is open until June 3, 2022. The FDIC has stated that subsequent guidance will be published on the topic of climate-related financial risks.
What are Climate-Related Financial Risks?
Climate-related financial risks include what are called “physical risks” and “transition risks.” Physical risks refer to the effects on people and property arising from isolated or specific events, such as hurricanes, wildfires, floods, and heatwaves, as well as less easily identified events like shifts in climate, higher average temperatures, changes in precipitation patterns, sea level rise, and ocean acidification. Transition risks refer to the stress to financial institutions stemming from shifts in policy, consumer and business sentiment, or technologies associated with the changes made in response to the government actions related to climate risks.
Board and Management
A financial institution’s board and management should demonstrate an appropriate level of understanding of the institution’s exposure to climate-related financial risk. The board and management should consider climate-related financial risk exposures when determining the overall business strategy, risk appetite, and financial, capital, and operational plans. The board and management should also address the potential impact of climate-related financial risk exposures on financial condition, operations, and business objectives. The board and management should further consider impacts on the institution’s reputation, LMI and other disadvantaged households and communities. Management should incorporate climate-related risks into policies, procedures, and limits to provide guidance on the institution’s approach to these risks considering the strategy and risk appetite determined by the board.
Institutions should incorporate climate-related financial risks when identifying and mitigating all types of risk, when appropriate. Regarding credit risk, climate-related financial risks should be considered as part of the underwriting and ongoing monitoring of portfolios. The FDIC indicates that effective credit risk management practices could include things like monitoring climate-related credit risks through different analyses and assessing potential changes in correlations across exposures or asset classes. The board and management should also look at credit risk appetite and lending limits related to these risks. The institution should further assess how climate-related financial risks could affect liquidity and incorporate those risks, if necessary, into their liquidity risk management practices.
Institutions should monitor how climate-related financial risks affect their exposure to risk related to changing prices. It has been suggested by the FDIC that bank management monitor interest rate risk and other model inputs for greater volatility or less predictability due to climate-related financial risks. While the industry is conducting research on how best to measure climate price risk, institutions should use the best measurement methodologies available to monitor these risks.
Institutions should consider how climate-related financial risk may negatively impact operations. According to the FDIC, good operational risk management includes assessing all business lines and operations, including third-party operations, and considering climate-related impacts on business continuity. The board and management should further consider how climate-related financial risks and risk mitigation measures affect the legal and regulatory landscape in which the institution operates. This could include possible changes to underwriting considerations related to flood insurance. It could also include fair lending concerns if the institution’s measures affect communities or households on one of the prohibited bases.
Given this and other recent guidance on the subject of climate-related financial risk, this appears to be a sign of things to come. Although this is stated to be aimed only at large institutions, it seems safe to assume that even small institutions will eventually have some role to play and regulations to define that role. Now is a good time for institutions of all sizes to contemplate these climate-related financial risks and begin considering how to prepare for anticipated future changes.