How Do Bank Regulators Treat Climate Change Risks?

How Do Bank Regulators Treat Climate Change Risks?

INSIGHTi
How Do Bank Regulators Treat Climate
Change Risks?
November 25, 2020
Introduction
Potential risks to the financial system from climate change have attracted growing attention in
government, academia, and media, raising questions about the roles of central banks and bank regulators
in addressing such risks. The U.S. central bank, the Federal Reserve (Fed), has responsibilities involving
financial stability, monetary policy, and banking supervision. Climate change—defined in a November 9,
2020, Fed report as “the trend toward higher average global temperatures and accompanying
environmental shifts such as rising sea levels and more severe weather events”—may impact each of
these. This could occur either through physical risks, such as greater storms and wildfires, or through
“transition risk,” meaning the risk that changed government policies or market perceptions might lead to
sudden asset price drops, such as for carbon-emitting industries. The Fed report on financial stability
warned that sudden hazards can bring about direct losses that could negatively impact banks’ investments.
It asserted that even slowly developing hazards such as rising sea levels could lead to sudden price drops
for bank investments if abrupt changes in public perceptions about such risks emerges. This Insight
focuses on the central bank’s role in banking supervision and climate change risks and on what the Fed
and other banking regulators have done to address such risks.
Reliance on Existing Broad Guidance
Federal Reserve Board Chair Jerome Powel outlined in an April 2019 response to a congressional request
that the Fed based its assessment of lending risks from climate-related events on a broader 1996
supervisory guidance and additional 1996 supervisory letter:
[T]he Board issued supervisory guidance in 1996, to ensure that bank management takes into
account all relevant risks in their underwriting and review practices. Our guidance with respect to
credit underwriting and asset quality provides supervisors the flexibility necessary to address risks
from severe weather events. In addition, our guidance also specifically addresses lending to sectors
where assessments of these risks are critical for due diligence and underwriting.
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The 1996 guidance, under the Federal Deposit Insurance Act, sets out the safety and soundness standards
regulators use to identify and address problems at insured depository institutions before capital becomes
impaired. Its standards are general, giving flexibility to bank supervisors. For instance, the 1996 guidance
with respect to asset quality requires banks to conduct periodic asset quality reviews to identify problem
assets and to estimate inherent losses in those assets. The standards for credit underwriting require banks
to “consider the nature of the markets in which loans wil be made.” Broadly, these standards may
encompass physical and transition risks for climate change as wel , Powel ’s letter suggests.
Calls for Climate Risk Stress Testing
Notwithstanding this 1996 guidance and its broad scope, some question whether climate-related risks
should be more overtly addressed in banking supervision. For instance, a 2020 report by the Commodity
Futures Trading Commission on “Managing Climate Risks in the Financial Sector” recommended the
adoption of climate risk stress testing for financial institutions.
Currently, the Federal Reserve stress tests large bank holding companies to make sure they hold sufficient
capital to operate under potential y adverse economic conditions and shocks. Such stress tests are
conducted periodical y through the Fed’s Comprehensive Capital Analysis and Review (CCAR) program.
Also, pursuant to the Dodd-Frank Wal Street Reform and Consumer Protection Act (P.L. 111-203 as
amended by P.L. 115-174) and its implementation, banks with consolidated assets of over $250 bil ion
must conduct their own annual stress testing, and those with $100 mil ion to $250 bil ion in consolidated
assets must undergo biannual stress testing. Although climate risk is not currently required in the CCAR
stress testing program for most individual banks’ annual stress testing, a March 2020 speech on climate
change and bank supervision by a New York Federal Reserve Bank official noted that a number of
financial institutions have begun using “climate-related scenario analysis” of their own accord to model
potential risks, such as those arising from severe weather events that might stress mortgage portfolios.
In addition, the New York State Department of Financial Services (NYDFS)—which oversees banks with
assets totaling $2.6 tril ion—announced on October 29, 2020, its requirements for climate risk stress
testing. The NYDFS said al New York–regulated banking organizations must begin integrating financial
risks from climate change into their governance frameworks, risk management, and business strategies.
NYDFS said compliance should include an assessment of climate-change-related risk factors such as
credit risk, market risk, liquidity risk, operational risk, reputational risk, and strategy risk.
International y, a group of central banks cal ed the Network for Greening the Financial System (NGFS)
has begun developing methodologies for conducting climate stress testing. At a November 10, 2020,
Senate Banking Committee hearing, Federal Reserve Vice Chair Quarles reportedly noted that the Fed
had sought membership in the NGFS group and expected to join by spring 2021. The European Central
Bank in May 2020 released a supervisory guide to climate-related and environmental risks that cal s on
banks to develop climate-related stress scenarios and consider such risks when developing strategy and
risk management plans.
Climate stress testing could pose significant chal enges that differ from the existing CCAR stress tests
already conducted by the Fed. For instance, one banking industry white paper noted that while there is
extensive historical data on the interactions between macroeconomic and financial variables, there is far
less data on the interaction between climate events and financial variables. Also, climate stress testing
would be aimed at measuring future effects that may not emerge in a linear fashion but may accelerate,
adding further difficulty to modeling, it noted. While, in the United States, existing CCAR stress testing
typical y extends to nine fiscal quarters, the effects of climate change are estimated on longer time
horizons—over multiple decades—adding to uncertainty. In addition, determining financial effects of
climate change involves the extent to which government policies may change. This remains highly
uncertain yet would likely have significant effects on any “transition risk.” Relative to traditional capital

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stress testing, climate stress testing appears more sensitive to modeling criteria and assumptions, which
could create greater variance in outcomes.

Author Information

Rena S. Miller

Specialist in Financial Economics

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