It’s a double shot of news today for regulatory compliance officers in the banking world: two major regulators promising a more rigorous review of climate risks within the coming year.
Michael Hsu, head of the Office of the Comptroller of the Currency, and Michael Barr, vice chair for supervision at the Federal Reserve, both gave speeches on Wednesday about their respective ambitions for bank regulatory policy. Climate risk received a heap of attention from both men, who said their agencies are developing plans to consider climate risks in their regulatory examinations — as well as guidance for banks to help them through that process.
“With climate-related risks, I believe we are much more exposed to failures of imagination — not asking enough “what if?” questions — than we are to failures of stringency or consistency,” Hsu said in his speech, delivered to a banking conference in New York.
Hsu specifically said he worries that the stress tests developed after the Dodd-Frank Act, which test banks for liquidity risk, might lull everyone into a cookie-cutter approach to assessing threats from climate risks. That’s a bad idea, Hsu said, and he vowed that OCC will use a “clean sheet of paper” approach to analyzing climate risks.
“In short, I am concerned that the muscle memory of capital stress testing is more likely to handicap climate scenario analysis than to help it,” Hsu said. “I believe a clean sheet of paper and an open mind to considering a wide range of risks and scenarios will yield richer and more actionable information than an approach that borrows heavily from capital stress testing.”
Several hours later, Barr gave his own speech at an event in Washington, his first since being confirmed as the Fed’s head of supervision earlier this summer. He had less to say about climate risk than Hsu, but touched on similar themes:
We intend to work with the Office of the Comptroller of the Currency (OCC) and the FDIC to provide guidance to large banks on how we expect them to identify, measure, monitor, and manage the financial risks of climate change. In addition, we are considering how to develop and implement climate risk scenario analyses. In that regard, next year we plan to launch a pilot micro-prudential scenario analysis exercise to better assess the long-term, climate-related financial risks facing the largest institutions.
So we have two of the most important banking regulators in the United States (the Fed for large banks, OCC for smaller and consumer banks) both promising more action on climate risk soon.
Bracing for Climate Risk Issues
None of this should be news to compliance and risk officers who’ve been paying attention. The Biden Administration first unveiled its ambitions for managing climate risk in an executive order the White House issued last year, and working with banks to assess how climate change might threaten the financial system was a big part of that. I
Indeed, the order specifically called for recommendations on how climate-related financial risk can be mitigated, “including through new or revised regulatory standards as appropriate.” Here we are 15 months later, with banking regulators preparing to do exactly that.
We can divide these climate-related risks into the three usual categories:
- Operational risks that might arise from actual weather events, such as heat waves overwhelming electricity grids or floods damaging data centers or other physical infrastructure.
- Financial risks that might come from a bank funding various projects that could, over time, become less valuable because climate change ruins the project. (Think investing in the redevelopment of a major urban waterfront, which might be underwater and useless by 2040; or extending home mortgages to the Southwest, which could shrivel up and die of thirst at roughly the same time.)
- Compliance risks from a bank unable to report its greenhouse gas emissions or other climate-change factors as required by the Securities and Exchange Commission or some other regulator.
Hsu and Barr are mostly talking about risks in the first and second categories: climate risks that might endanger a bank’s safety and soundness. A bank that fails to serve its customers or becomes an unreliable counter-party might then pose greater risk to other banks and the financial system as a whole, and that’s what OCC and the Fed want to avoid.
The grand question, of course, is how OCC and the Fed will translate that concern into questions they would ask in a regulatory review, or scenarios they would pose to a bank during a climate stress test. As Hsu himself said, the regulators don’t want to rely on the practices they developed during Dodd-Frank stress tests for liquidity risk — but what, then, takes their place?
Until OCC and the Fed come up with some specific examples — until they start filling in that clean sheet of paper, to use Hsu’s words — compliance teams can’t really prepare much of a response. You won’t know what data about climate risk to collect or how to report it.
Heck, I’m still trying to figure out who at a large bank would be responsible for replying to a climate stress test. The regulatory compliance team? The ESG function, assuming you even have one? The Dodd-Frank stress test team? Somebody else? Even the OCC doesn’t have a chief climate risk officer at the moment (although one is coming soon, Hsu says). That says something about how newfangled the whole idea of climate risk still is, even today.