How climate risk is already creeping into banking policy

WASHINGTON — How the Biden administration’s focus on climate risk will affect regulators’ oversight of the U.S. financial system is, slowly but surely, coming into view.

In May, the administration directed federal agencies to paint a picture of the country’s economic vulnerabilities related to climate change and craft policies to address them. The goal was to mitigate risks to homeowners, consumers, businesses and workers, the financial system, and the federal government.

Just last week, the White House issued a fact sheet detailing six core pillars of its approach to combating climate risk. Those pillars include boosting the financial system’s resilience, protecting citizens’ savings and pensions, making the government’s procurement practices greener, incorporating climate risk in underwriting of government-backed mortgages, and building more resilient infrastructure.

The administration’s directives have mobilized agencies to act, but in some cases Biden-appointed regulators were already moving aggressively to address climate-related risks.

Earlier this month, Federal Reserve Board Gov. Lael Brainard said the central bank will subject financial institutions to “scenario analysis” of their climate-related risks, a process that the Fed says is distinct from traditional stress tests. In July, the Office of the Comptroller of the Currency announced the appointment of Darrin Benhart as the agency’s Climate Change Risk Officer, and said the OCC was joining the international Network of Central Banks and Supervisors for Greening the Financial System.

An upcoming report by the Financial Stability Oversight Council may put more flesh on the bone about how regulators will view climate risks in bank supervision. Meanwhile, some agencies have already moved ahead more aggressively. For example, the Securities and Exchange Commission is working on a rule to require publicly traded companies to issue disclosures about their impact on and risks from climate change.

Many bankers, including those at many of the country’s largest institutions, have acknowledged the looming business risks from extreme weather events, a societal transition to cleaner energy sources and other consequences of a rapidly heating planet.

At the same time, many financiers remain leery of climate regulations that could burden them with significant new disclosure requirements, tie their hands when lending to certain industries or even increase capital requirements.

It is certain that the Biden administration will remain on a path to try to blunt the impact of climate change on the U.S. economy. What follows is a breakdown of the biggest anticipated policy moves on the horizon for banks and other financial institutions.

FSOC report

One of the main assignments given to financial regulators by the Biden administration in May’s executive order was a major report from the Financial Stability Oversight Council. Led by agency heads across the government and chaired by Treasury Secretary Janet Yellen, FSOC was tasked by the White House with “assessing, in a detailed and comprehensive manner, the climate-related financial risk” to the U.S. economy.

The FSOC report, which could be released as soon as this week, will focus on the options regulators have to incorporate climate risk into their supervision of the financial system. According to the executive order, the report will discuss “any actions to enhance climate-related disclosures by regulated entities,” as well as potential legal or administrative impediments the Biden administration may face before enacting such changes.

“Financial regulators, financial institutions, and investors need to have access to the best information and data to measure climate-related financial risks,” Secretary Yellen said in May. “FSOC will work with Council members to improve climate-related financial disclosures and other sources of data to better measure potential exposures.”

It remains unclear how ambitious the report will be. The Washington Post reported in September that “Treasury officials appear unlikely to embrace the most dramatic steps pushed by climate advocates,” such as limitations on lending to the oil and gas sector.

“The administration’s policy is to mitigate both climate-related financial risk and its drivers,” said David Arkush, director of Public Citizen’s climate program, in a press release earlier this month. “To meet this charge, the report must acknowledge that fossil fuel finance is a primary driver of systemic climate risk and that our financial system today is completely misaligned to this reality and on a collision course with the administration’s climate agenda.”

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SEC climate disclosures

The Securities and Exchange Commission emerged as one of the most active financial regulators in trying to measure climate change risk in the U.S. financial system, even before Chair Gary Gensler’s arrival at the agency in April. One of the agency’s highest-profile efforts is developing more robust climate disclosures for publicly traded companies, including many of the nation’s largest banks.

The SEC has signaled that it is considering a framework developed by the Task Force on Climate-Related Financial Disclosures. The international group breaks down carbon emissions into three categories: Scope 1 covers direct emissions from company-owned sources, such as corporate vehicles; Scope 2 encompasses indirect emissions, such as what results from from office heating systems; and Scope 3 includes emissions associated with a business’s supply chain partners.

In March, the SEC requested public input on how the agency could best regulate climate disclosures and asked a number of questions, including whether the rules should require emissions data under scopes 1, 2, and 3. The SEC also published a separate bulletin in September containing a sample letter that public companies may receive if the agency determines it wants more information about a firm's climate risk exposure. Both are seen as a prelude to a more formal proposal at some point.

Bankers remain concerned that they may be responsible for calculating Scope 3 emissions, which they say could trigger a potentially massive amount of disclosure and recordkeeping burden for financial institutions and their customers depending on how the requirements are structured.

“The ability of registrants to produce comprehensive information about their emissions profile and climate risks is at an early stage,” the Bank Policy Institute wrote in a comment letter to the SEC earlier this year, adding that “these issues are magnified in the banking sector.” “Banking organizations are dependent upon information from their clients to understand the emissions profile and climate risks of their lending activities,” the BPI wrote. “Gathering this information from clients — who themselves will take time to be able to produce meaningful data — will take a significant amount of time.”

Underwriting federally backed mortgages

The White House fact sheet this week discussed how agencies that provide mortgage backing and other federal loan support are undertaking efforts to bolster underwriting, credit standards and servicing procedures to account for climate-related risks.

The Department of Housing and Urban Development — which is home to the Federal Housing Administration — along with the Department of Veterans Affairs, the Agriculture Department and the Treasury Department are “each working to enhance their federal underwriting and lending program standards to better address the climate-related financial risks to their loan portfolios, while ensuring the safety and security of communities most impacted by climate change,” the White House said.

In HUD’s climate adaptation plan developed at the direction of the White House, the department outlined several agenda items for FHA and Ginnie Mae in the following years. HUD noted that one major threat is the exposure of FHA’s mutual mortgage insurance fund to increased defaults and losses due to extreme weather events and declining property values in communities vulnerable to climate change.

By 2023, FHA is expected to have assessed different approaches for incorporating climate risk into its underwriting criteria, and to consider reducing mortgage insurance premiums to encourage property owners to “adopt higher building standards,” HUD’s report said.

FHA is also supposed to assess the benefits and risks of offering a new loan product by 2025 in order to provide low-cost financing for borrowers that are making energy efficiency and climate risk mitigation improvements.

Meanwhile, Ginnie Mae will be tasked through 2023 with strengthening its analytical capabilities for environmental assessments, as well as exploring how it can leverage its current systems to support the environmental justice initiatives of government-backed loan programs.

Updating the National Flood Insurance Program

The Federal Emergency Management Agency on Oct. 12 published a request for information seeking feedback on how to update the National Flood Insurance Program’s standards to better align the program with new data on flood risks and protect local communities from potential severe weather events.

Among the proposals FEMA sought comment on is a national requirement for home sellers to disclose previous flood damage to prospective buyers, as well as new elevation requirements for construction in coastal and flood-prone areas.

“Through a new Request for Information, FEMA will gather stakeholder input to make communities more resilient and save lives, homes and money through potential revisions to standards that have not been formally updated since 1976,” the White House said.

Comments on the request for information are due to FEMA by Dec. 13.

The NFIP provides flood insurance to more than five million property owners, renters and businesses, and allows mortgage lenders, real estate agents, homebuilders and the rest of the housing industry to close deals on homes in floodplains. Those looking to buy property in certain FEMA-designated flood areas are required to purchase flood insurance in order to qualify for a mortgage.

However, the program has operated at a deficit since Hurricane Katrina.

Climate stress tests?

Bank regulators have also been active on numerous fronts.

In Brainard’s speech at the Federal Reserve Bank of Boston, she said Fed’s the “scenario analysis” exercises for banks are meant to identify potential physical risks from severe weather events as well as the transition risk from changing consumer behaviors and government policies.

“Although we should be humble about what the first generation of climate scenario analysis is likely to deliver, the challenges we face should not deter us from building the foundations now,” Brainard said.

While the exercises are designed to be merely informative and separate from the central bank’s traditional stress tests, some observers believe that climate change risks may have a greater presence in stress tests in the future.

Meanwhile, the OCC’s appointment of a climate change risk officer and membership in the NGFS suggests the national bank regulator may become more active in the coming months and years.

Testifying before Congress in May, acting Comptroller of the Currency Michael Hsu suggested the agency could take a “two-pronged approach” to initial actions to address climate risks. The first is to engage with other regulators, and the second is to “support the development and adoption of effective climate risk management practices at banks.”

“The OCC’s approach to date has been to monitor climate change-related developments at banks. I have asked staff to build on this approach and develop options for taking more concrete actions,” Hsu said. “These could include hosting or co-hosting a conference focused on climate change risk management practices at financial institutions, performing a thorough review of our existing policies, and evaluating a range of bank practices relative to identification and measurement, and risk management approaches.

“Managing the risks of climate change will require a collective effort and we will seek opportunities to hear from all stakeholders of our federal banking system.”