As many of our members begin to work on recovering – and assisting the communities they service in recovering – from two recent intense hurricanes to hit the United States, it seems timely to take a look at the climate-related risks that banks are currently facing. A recent bulletin from the Federal Housing Finance Agency (FHFA) provides guidance to Federal Home Loan Banks (FHLBanks) on how they should prepare for future natural disasters from a risk management perspective. While this guidance is limited to FHLBanks, it may also serve as a useful starting point for other banks looking to ensure that they are effectively managing climate-related risks.
Under the FHFA guidance, the bank’s board, in fulfilling its obligation to ensure safe and sound operations, should oversee the management of climate-related risks. This should include incorporating climate risk into the three lines of defense to ensure that appropriate responsibilities are delegated to business lines and audit, in addition to risk management. It will also require the board to be aware of relevant risks, laws and regulations, metrics, disclosure and reporting requirements, and pertinent risk management activities, to ensure that the board’s decision making is well-informed.
Risk assessments will be the starting point for effective climate-related risk management. The FHFA guidance lists five example risks in a non-exhaustive list:
- Credit risk: climate change may materially alter collateral values; extreme weather events may affect consumers’ creditworthiness to the extent that they may suffer physical harms or be required to relocate.
- Liquidity risk: cash inflows and outflows may be affected by climate events.
- Market risk: climate change may lead to sudden shifts in real estate markets.
- Operational risk: climate events may lead to business disruptions for banks, third parties, and other business partners.
- Legal and Compliance risk: climate-related risks are identified as a fair lending concern for FHLBanks
These risks should be incorporated into the bank’s overall risk framework and risk appetite, which will in turn be used to shape existing policies and procedures and inform the bank’s overall strategy and business objectives. Ongoing risk mitigation and monitoring should be aligned with the risk appetite and based on relevant metrics and data.
The metrics and data that are relevant and available may change over time, so it is also important that banks continue to enhance the collection and maintenance of this information in order to quantify exposures and assess the effectiveness of any mitigation measures taken. The risk management process should endeavor to identify and close any gaps in the available data to improve the accuracy of the bank’s methods and modeling. The FHFA encourages banks to use this data to improved climate-related scenario analyses, which it describes as an important approach for identifying, measuring, and managing climate-related financial risk.
Hurricanes are, of course, at top of mind in the aftermath of Helene and Milton, which serve as a reminder that disaster preparedness is essential for banks in terms of ensuring physical safety and serving their communities during times of greatest need. The FHFA guidance focuses on a different type of disaster preparedness that includes responding to sudden, catastrophic events and also long-term planning to manage the cumulative risks presented by changes in the climate.