Climate change and climate risk management for banks
It is important that financial institutions stay abreast of the hot button area of climate change and climate risk ...”
Climate change and risk management have become a hot button topic for financial institutions in recent years as a result of the rising concern by policymakers, international organizations, financial regulators and so many others. There has been such a push in recent years for a more environmentally friendly world as we see changes in organizational resources and operations, investor expectations, environmental activists and even the expectations of the current administration. With all the focus on environmental safety, considering the impacts and learning how to manage the risk is the inevitable for financial institutions.
What Is Climate Change?
When it comes to climate change, this is considered to be a change in global or regional climate patterns. More specifically, a change in global or regional climate patterns from the mid-20th century through today, which has been largely attributed to an increase in atmospheric carbon dioxide levels which are produced by fossil fuel usage. It can be a controversial topic among various group but whatever side of the fence you stand on when it comes to climate change, there are climate-related financial risks faced by banks and managing that risk can be critical.
What Type of Risk Should Financial Institutions Consider?
According to the varying regulatory agencies, climate change and the transition to a low carbon economy have been identified as factors which have contributed to emerging risks in which financial institutions and the overall financial system of the United States are faced with. The agencies indicate that banks will likely be impacted by physical risks and transition risks associated with climate change. The harm to people and property which arises from acute, climate-related events (flooding, hurricanes, heatwaves, etc.) is considered physical risks. Stresses to financial institutions as a result of the shifts in policy or consumer or business sentiments, or changes in technology in order to limit the impact of climate change are considered transition risk. Basically, transition risk is the risk as a result of the transition to a more environmentally friendly process or way of conduction business and operations. Other risks that financial institutions should consider as it relates to climate change and the environment include credit risk, market risk, liquidity risk, operational risk and reputational risk. Banks must consider the various areas of risk, especially as they consider the safety and soundness of their institution.
Principles for Managing Climate Related Risk
While there isn’t specific regulatory guidance for achieving compliance and managing the risk related to climate, at the current time, we are likely to see this type of guidance in the near future. Regulatory agencies have addressed the issues and have requested feedback for managing the risk and are looking at implanting regulatory requirements for large financial institutions. This would include banks with over $1 billion in assets. The Office of the Comptroller of Currency along with other regulatory agencies have released guidance, requests for information and a set of principles by which financial institutions should consider in managing climate related risks. The information released by the OCC includes a set of general principles as well as the specific areas of risk management.
The general principles touch on governance; policies, procedures, and limits; strategic planning; risk management; data, risk measurement, and reporting; and scenario analysis. The general principles provide guidance for developing an effective framework that is essential to the bank’s safe and sound operations. The principles outline expectations for board and senior management oversight, guidance for developing a written program, the areas of consideration for planning which should take into account the bank’s overall business strategy, risk appetite, and financial, capital and operational plans. It is also important that management is involved in the oversight of the development and implementation process for identifying, measuring, monitoring and controlling climate-related financial risk exposure within the bank’s management framework. Sound climate risk management is dependent upon the availability of relevant, accurate, and timely data; therefore, management should incorporate climate related financial risk information into the bank’s internal reporting, monitoring, and escalation processes to facilitate timely and sound decision-making across the bank. An important approach for identifying, measuring, and managing climate-related risks is the development of climate-related scenario analysis.
In order to ensure this framework is effective and successful, financial institutions should consider a risk assessment process as part of their sound risk governance framework. This will ensure that the board and senior management are able to identify emerging risk in order to develop and implement the appropriate strategies to mitigate and manage the risks. The guidance issued by the OCC suggests that financial institutions should consider incorporating climate-related financial risks when identifying and mitigating all types of risk. While the agencies will eventually elaborate on risk assessment principles in subsequent guidance, it is suggested that financial institutions consider credit risk, liquidity risk, other financial risk, operational risk, legal/compliance risk and other nonfinancial risk.
Conclusion
While there isn’t currently a specific set of guidance that financial institutions must abide by when it comes to climate risk, compliance and management, this is an area which all banks should begin considering from a safe and sound banking standpoint. It is looking like the future guidance related to climate risk will only apply or be required by large financial institutions, however, the guidance and risk considerations should be contemplated by institutions of all sizes. Risks can impact even smaller institutions, therefore, taking a proactive approach rather than a reactive response is always the best plan of action. It is important that financial institutions stay abreast of the hot button area of climate change and climate risk, from a compliance and risk management perspective, as the society in which we are living continues to set a higher standard for an environmentally friendly world.