One of the country’s top banking regulators has outlined five questions that large banks’ boards should be asking about climate change, with a notable nudge that the banks’ management teams “hopefully should be able to answer these questions with greater accuracy and confidence” within 12 months.
In other words, get on with things, banking industry. Your regulators want to start seeing progress.
The remarks came Monday from Michael Hsu, acting chief of the Office of Comptroller of the Currency. OCC said Hsu’s comments were intended “to promote and accelerate improvements in climate risk management practices at their banks.” They come on the heels of the COP26 global climate summit in Scotland, but otherwise weren’t tied to any specific climate change announcement from the Biden Administration.
Anyway, Hsu offered five questions that the boards of large banks should be asking their management teams these days:
- What is our overall exposure to climate change?
- Which counterparties, sectors, or locales warrant our heightened attention and focus?
- How exposed are we to a carbon tax?
- How vulnerable are our data centers and other critical services to extreme weather?
- What can we do to position ourselves to seize opportunities from climate change?
As we mentioned earlier, Hsu didn’t expressly say that boards must ask these questions, or that banks must be able to provide clear and specific answers. But he did say that banks should start factoring climate change risks into their risk management calculations, and that OCC plans to issue “high-level framework guidance for large banks on climate risk management” by the end of this year.
Hsu’s remarks also follow pronouncements from the Biden Administration earlier this year that financial regulators will start paying much more attention to climate issues, and that consequently, banks will need to start doing the same. So we’re getting closer to specific compliance obligations, but not fully arrived yet.
The Most Important Climate Question
Among Hsu’s five questions, and the commentary he provided with them, the one that came closest to describing a risk assessment methodology was the first: What is the bank’s overall exposure to climate change? Hsu recommended that banks try to answer that question by developing scenario-planning capabilities that could tinker with various climate change possibilities.
These are my examples rather than Hsu’s, but consider: What if all the bank’s real estate investments within 20 miles of the coast were devalued by 20 percent due to rising sea levels? What if investments in coal or natural gas developments turned into stranded assets with little or no value, as society moves to embrace clean energy? What if extreme weather events keep pushing up the cost of recovery from those disasters? (The total cost of U.S. weather and climate disasters has exceeded $690 billion in the last five years, Hsu noted.)
Hsu compared that scenario-planning to the Comprehensive Capital Analysis and Review (CCAR) stress tests that large banks already undergo with the Federal Reserve. The Fed devises various economic scenarios from rosy to disastrous, and then tries to understand which banks might pose systemic risk to the U.S. financial system under what adverse conditions. Bank boards should undertake the same sort of stress-testing analysis, Hsu said, for climate change.
“Banks can and should engage in what I call ‘small s’ scenario testing — that is, asking more granular ‘What if?’ questions that directly affect parts of a bank’s portfolio,” Hsu said. “For banks with strong risk management capabilities, this is bread-and-butter stuff … Boards should push senior management hard to develop scenario analyses, both top down and bottom up, as doing scenario analysis well takes time. But time is running out.”
If you want more specific examples of climate change scenarios that you could plan against, try using material from the Network for Greening the Financial System, a coalition of central banks and financial regulators. The NGFS published a bundle of scenarios and related material earlier this year that you could shoehorn into risk management models you might be developing.
Hsu’s point about scenario-planning for climate change is valid for any company, regardless of whether you’re in the banking sector. Banks in particular, however, already should have risk modeling capabilities for CCAR compliance and other concerns — so you folks should, in theory, be able to move quickly on integrating climate risks into your analyses too.
Other Points in the Other Questions
Hsu’s other four recommended questions are all meant to help boards sharpen their thinking about climate change risks. For example…
Which counterparties, sectors, or locales warrant our heightened attention and focus? Boards should assess two types of risks here. First are the physical risks of climate change that might arise from regions battered by extreme weather or rising sea levels. Second are transition risks, as the world moves away from fossil fuels and toward green energy. A bank might, for example, find that some of its major markets in coal country are no longer lucrative, or that large clients have balance sheets suffering with stranded assets no longer worth what they once were.
How vulnerable are our data centers and other critical services to extreme weather? This one is pretty self-explanatory. Indeed, large banks that also operate broker-dealer subsidiaries are already subject to FINRA rules requiring broker-dealers to plan for extreme weather events, pandemics, and the like; to assure that the firms can maintain customer service. So you could review business continuity and disaster recovery plans to see how much those documents incorporate climate change scenarios in their planning.
What can we do to position ourselves to seize opportunities from climate change? Hsu’s not wrong to note that astute firms will be able to turn a pretty penny from our future climate strains. He says it best: “Just as strong credit risk management capabilities can provide the assurance and confidence needed for a bank to make risky credit decisions prudently, strong climate risk management capabilities can enable the same prudent risk taking with regards to climate-related business opportunities.”
What to Do With Hsu’s Comments
For bank boards to address climate change effectively, they need to assign responsibility for it. That is, some committee of the board has to put climate change into its charter and those directors need to start asking questions about the subject.
That might be a bit tricky, since climate change could fall under the jurisdiction of several committees — and of course, when anyone can take responsibility for a problem, that often means that nobody does.
For example, Bank of America has both a Corporate Governance, ESG, and Sustainability Committee, and an Enterprise Risk Committee. But neither committee actually mentions the word “climate” in its charter.
The governance and ESG committee charter does say the committee should review BofA’s “ESG and sustainability strategy, initiatives and policies; and receive updates from the company’s management committee responsible for significant ESG and sustainability activities.” Meanwhile, the enterprise risk committee charter says that committee should oversee management activities “with respect to capital management and liquidity risk,” including those CCAR stress tests.
Well, as Hsu outlined in his comments, climate change risks could fall into either category. So first and foremost, a bank board of directors needs to figure out whether such dual oversight is efficient and productive. My gut tells me Hsu would say no, it isn’t.
I also can’t help but notice that Hsu’s comments are just that: comments. They’re not guidance; they’re not rules. So perhaps his five questions are just a warm-up exercise to capture board directors’ attention during the Q4 meeting. After all, Hsu did also say that OCC will be providing more specific “high-level framework guidance for large banks on climate risk management” by the end of this year. Maybe he’s priming the audience for the bigger stuff still on its way.