Federal Reserve Proposes Climate Risk Guidance for Large Financial Institutions

Nicola Higgs, Betty M. Huber, and Arthur S. Long are Partners at Latham & Watkins LLP. This post is based on a Latham memorandum by Ms. Higgs, Ms. Huber, Mr. Long, Pia Naib, Anne Mainwaring, and Deric Behar.

On December 2, 2022, the Board of Governors of the Federal Reserve System (Federal Reserve) published proposed Principles for Climate-Related Financial Risk Management for Large Financial Institutions (the Proposal). The Proposal urges large financial institutions [1] to consider how best to identify, measure, monitor, and control the various risks associated with climate change over a variety of time horizons. It also specifies that large financial institutions should monitor microprudential risks, including credit, market, liquidity, operational, and legal and compliance risks, as well as other financial and nonfinancial risks that could arise from climate change.

The Proposal aims to support financial institution boards of directors and management in incorporating mitigation of climate-related financial risks into their broader risk management frameworks, consistent with safe and sound practices and the Federal Reserve’s rules and guidance on sound governance.

Large financial institutions are defined as those with over $100 billion in assets that are subject to Federal Reserve supervision, including the US operations of non-US banking organizations. The Federal Reserve’s guidance is founded on the premise that climate change poses an emerging risk to the safety and soundness of financial institutions and the financial stability of the United States.

Principles of Climate Risk Management

The Proposal addresses both the physical [2] and transition risks [3] associated with climate change. The Proposal serves as a high-level framework and covers six key aspects of climate-related financial risk management: (i) governance; (ii) policies, procedures, and limits; (iii) strategic planning; (iv) risk management; (v) data, risk measurement, and reporting; and (vi) scenario analysis.

Governance: A financial institution’s board of directors should understand the effects of climate-related financial risks on the institution, oversee risk-taking activities, allocate resources to support climate-related risk management, and assign accountability. Management should implement policies in accordance with the board’s strategic direction; oversee the development and implementation of processes to identify, measure, monitor, and control climate-related financial risks; and regularly report to the board.

Policies, Procedures, and Limits: Management should incorporate climate-related financial risks into the financial institution’s policies, procedures, and limits in line with the strategy and risk appetite that the board sets.

Strategic Planning: A financial institution’s board of directors and management should consider climate risk when setting overall business strategy, risk appetite, and capital plan. The board and management should also consider how climate-related financial risk impacts other operational and legal risks, and stakeholders.

Risk Management: Management should oversee the development and implementation of processes to identify, measure, monitor, and control climate-related financial risk exposures within existing risk management frameworks, develop processes to measure material climate-related financial risks, communicate those risks to internal stakeholders, and incorporate them into the financial institution’s risk management system, including internal controls and internal audit.

Data, Risk Measurement, and Reporting: Management should incorporate climate-related financial risk information into internal reporting, monitoring, and escalation processes, as well as monitor developments in data, risk measurement, modeling methodologies and reporting, and incorporate them into climate-related financial risk management.

Scenario Analysis: Management should develop and implement forward‑looking climate‑related scenario analysis frameworks in a manner commensurate to the financial institution’s size, complexity, business activity, and risk profile. Such frameworks should contain clearly defined objectives that reflect a financial institution’s overall climate-related financial risk management strategies. The Proposal suggests that the scenario analysis framework could have various objectives, such as estimating climate-related exposures and potential losses across a range of scenarios, including extreme but plausible scenarios. The Proposal notes that these scenario analysis exercises differ from traditional stress testing models that focus on the potential impacts of transitory shocks to near-term economic and financial conditions. (The Federal Reserve relatedly announced in September 2022 that it was conducting a pilot climate scenario analysis exercise in early 2023 with the six largest US financial institutions.)

Note that if the March 2022 climate risk disclosure proposal of the US Securities and Exchange Commission (SEC) is finalized, it would require SEC registrants to disclose climate scenario analysis that the registrant uses to assess the impact of climate-related risks. The Proposal is silent as to the significant additional SEC disclosure obligations that its scenario analysis provision could impose on financial institutions.

Management of Risk Areas

The Proposal also instructs management to be aware of how climate risk assessment and mitigation relates to other traditional types of risk, such as credit risk, liquidity risk, other financial risks (e.g., interest rate risk, price fluctuation risk), operational risk, legal and compliance risk (e.g., fair lending concerns), and other non-financial risks.

The Governors Weigh In

The Proposal was supported by six of seven Federal Reserve governors.

Governor Michelle Bowman issued a statement of tentative approval for publishing the Proposal, for the targeted purpose of soliciting public opinion, but said she will determine any later vote to finalize the Proposal based on the feedback obtained. She specifically noted that the Federal Reserve should “consider the costs and benefits of any new expectations … [and] additional obligations on firms.”

Governor Christopher Waller issued a brief statement of dissent, on the grounds that he disagrees with the premise that “climate risk poses a serious risk to the safety and soundness of large financial institutions and the financial stability of the United States.” He said existing financial institution stress tests are sufficient to determine financial institution resiliency in the face of severe macroeconomic shocks.

US Banking Regulators in Alignment

The Proposal comes just over two years after the Federal Reserve first acknowledged the impact of climate risks on financial stability in its annual Financial Stability Report (for more on the November 2020 Report, see this blog post). Chairman Jerome Powell has since maintained that climate risk mitigation follows from the Federal Reserve’s “assigned legal mandates.” Indeed, the Proposal follows from the October 2021 Climate Report of the Federal Stability Oversight Council (FSOC Report), whose voting members include the heads of the Federal Reserve, the SEC, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Commodities Futures Trading Commission (CFTC), and five other financial regulators. The FSOC Report called upon all member agencies to promote consistent, comparable, and decision-useful disclosures that allow investors and financial institutions to take climate-related financial risks into account in their investment and lending decisions.

According to Federal Reserve’s Board Memo, the Proposal is substantially similar to those issued by the OCC in December 2021(see here) and the FDIC in March 2022 (see here). In fact, the Federal Reserve noted that its staff developed the Proposal in consultation with staff of the OCC and the FDIC, and “intends to work with those agencies to promote consistency in the supervision of large banks through final interagency guidance.”

The Proposal contains some noteworthy changes from the OCC and FDIC principles:

  • Governance: The Federal Reserve sought to clarify the roles of boards versus management to alleviate director concerns and better align with the general concept that boards of directors have an oversight and information receiving function, whereas management’s role is to implement risk controls and report relevant information to the board.
  • Management of risk areas: The Proposal omits a sentence included in the OCC and FDIC versions that the agencies “will elaborate on these risk assessment principles in subsequent guidance.” The preamble to the Proposal refers to the principles and “any subsequent climate-related financial risk guidance,” which falls short of the OCC and FDIC’s statement that there “will” be elaboration in future guidance, and the Proposal by its terms is limited to “financial risk.”

In light of Governor Bowman’s objection that the Proposal would impose a host of new obligations on affected financial institutions, the Proposal notably does not discuss costs. The Federal Reserve is not subject to statutes that have led agencies like the SEC and CFTC to undertake a cost-benefit analysis when issuing proposed rules, but the Proposal would clearly require extensive compliance obligations.

The Proposal was published in the Federal Register on December 8, 2022, and comments must be received by February 6, 2023.

Interaction With Global Regimes in Managing Climate-Related Financial Risks

The Proposal reflects the approach seen in many jurisdictions to manage the threat to the stability of the financial system and the safety and soundness of regulated institutions by introducing measures in relation to the management of climate-related financial risks. In the UK, the Bank of England was the first central bank to set supervisory expectations for banks and insurers on the management of climate-related financial risks, covering governance, risk management, scenario analysis, and disclosure. In the UK, addressing the risks from climate change has been embedded as a core component of the supervisory approach and forms part of the “business as usual” supervision that banks and insurers are subject to. In Europe, the European Central Bank has an advanced program in place in relation to the management of climate-related financial risks, including thorough climate risk stress testing. Global banks will therefore need to consider the proposed principles in light of their wider framework and obligations in relation to the management of climate-related financial risks.

Endnotes

1The Proposal defines “financial institution” to include state member banks, bank holding companies, savings and loan holding companies, foreign banking organizations with respect to their US operations, and non-bank systemically important financial institutions (SIFIs) supervised by the Federal Reserve.(go back)

2The Proposal defines physical risks as the harm to people and property arising from acute, climate-related events, such as hurricanes, wildfires, floods, and heatwaves, and chronic shifts in climate, including higher average temperatures, changes in precipitation patterns, sea level rise, and ocean acidification.(go back)

3The Proposal defines transition risks as stresses to institutions or sectors arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes that would be part of a transition to a lower carbon economy.(go back)

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