Should banking regulators require banks they supervise to stress test their loan and investment portfolios for any risks associated with climate change?
It’s a question being debated among bankers, regulators and shareholder groups worldwide amid increasingly dire reports that the planet is warming, but there is broad disagreement about how far regulators should go.
Central banks abroad have formed working groups to examine global warming’s risks to the financial system and some, including the Bank of England, are considering incorporating the impact of higher temperatures into their evaluations of banks’ loan books. If rising sea levels threaten coastal property values or persistent drought conditions pose risks to agricultural loan portfolios, the thinking goes, then regulators and investors ought to know about it.
Here in the U.S., though, the idea of
The responses from the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. disappointed Lauren Compere, the managing director of Boston Common Asset Management, an investor firm that focuses on environmental and social responsibility. The firm holds large investments in dozens of banks in the U.S. and abroad.
“U.S. regulators are sitting on the fence. They’re not going to take the lead in addressing this issue,” Compere said in an interview Wednesday. “Every other country in the world, including regulators and bank supervisors, are taking a much more advanced approach than the U.S. I will say I’m not surprised at the response, but if I were in Congress, I wouldn’t be satisfied.”
In a letter dated April 18, Fed Chairman Jerome Powell said that the agency does consider severe weather events in its guidance to banks and supervisors and when it assesses the overall stability of the financial system. But his remarks stopped there. He characterized severe weather events as shocks to the system and therefore “inherently difficult to predict.”
“The board's framework provides a systematic way to assess financial stability; however, some potential risks do not fit neatly into that framework,” Powell wrote. “Some potential risks are difficult to quantify and especially if they materialize over such a long horizon that methods beyond near-term analysis and monitoring are appropriate.”
The FDIC and OCC offered similar, shorter, responses. The FDIC said that it requires banks to show that they have made plans for “any event that leads to operational disruption.”
The OCC said that it has issued guidance on contingency planning for severe weather events and that “banks have deep experience assessing and mitigating risks of all kinds, including those associated with natural disasters and severe weather.”
Sen. Brian Schatz, D-Hawaii,
“There is no way to say this diplomatically. Their answers were garbage,” he wrote. “The American agencies that oversee the financial system have decided to ignore climate change.”
The responses of U.S. regulators stand in stark contrast to the actions of regulatory bodies in other countries.
Last year, eight central banks formed the Network for the Greening of the Financial System to share best practices and insights for ensuring the financial system’s resilience against climate risk.
Now at more than 30 members strong, that group issued its first report in April. Among other things, it recommended that central banks and supervisors start incorporating climate risk into their evaluations of both the broader financial system and individual banks
Meanwhile, Mark Carney, the governor of the Bank of England, and François Villeroy de Galhau, governor of the Banque de France, recently published an article in The Guardian, calling on regulators to incorporate climate risk into their stress tests. They said that a “massive reallocation of capital” would be needed to stay below a 2-degree increase in global temperatures and also urged more collaboration between countries on the issue.
“If some companies and industries fail to adjust to this new world, they will fail to exist,” they wrote.
Mindy Lubber, the CEO of the Boston-based nonprofit Ceres, said that U.S. regulators’ responses to Sen. Schatz were “a start” and “not unimportant.” However, Lubber said she was disappointed that regulators focused mostly on the physical risk, or the losses that banks could sustain in severe weather events, like hurricanes and wildfires. She said that regulators should also address transition risk, or the risks associated with a greater shift to clean energy. Banks that have loaned and invested heavily to oil and gas companies, for example, could face losses if those industries become less viable in a lower-carbon economy.
“Transition risks pose a greater danger to our economy in the long run. Specific physical risks happen in specific places. They’re significant, and they ought to be noted,” she said. “We’ve got to be able to weave in transition risks.”
To their credit, some banks
Others, like TD Bank, have committed to financing more renewable sources of energy. And community banks have made their own small improvements, installing solar arrays to supply energy or reducing paper waste in their branches.
In a report issued in January, Wells Fargo said that among other corporate reforms it had
Wells Fargo declined to further discuss this framework with American Banker.
Members of the House Financial Services Committee asked the CEOs of JPMorgan, BofA and Citi about climate change at a recent hearing. The CEOs highlighted their banks’ investments in clean energy projects and agreed that climate change is a risk, though JPMorgan CEO Jamie Dimon said it was “not directly” a risk to the financial system.
Rep. Rashida Tlaib, D-Mich., asked, “Would you be willing to restrict, limit or change what your bank finances … if you found out it is making the climate change worse in our country or in our world?”
“We already have started that. We agree it's important,” Dimon replied. “In the meantime, the United States does need energy to eat, drive, get here, heat, ventilate hospitals, and there's a smart way to do this and a not-smart way to do this.”
Dimon went on to suggest that a carbon tax or carbon dividend might be the way to encourage more investment in clean energy. Neither bankers nor legislators addressed stress testing in that hearing.
The Task Force on Climate-Related Financial Disclosures, formed in 2015 by the Financial Stability Board, recommends scenario analysis — examining risks in loan books under various warming scenarios — as a best practice. So does the Network for Greening the Financial System.
The American Bankers Association declined to weigh in specifically on whether banks should conduct scenario analyses for climate risk, saying only that some banks do consider weather events in their own risk management programs.
“As they make underwriting decisions, banks assess a variety of risks and typically take into account past and predicted future outcomes and potential economic shocks that could come from natural disasters and severe weather,” ABA spokesman Ian McKendry said in an email.
The Chartered Banker Institute in Edinburgh, Scotland, takes the position that scenario analysis for climate risk should be voluntary, at least for now, said CEO Simon Thompson. Instead, regulators should encourage banks to stress test for climate risk and provide clear, consistent guidance on how to do so, he said.
“All financial services firms are required to report on material risks, and for the great majority of firms climate risks are material. So to some extent, it shouldn’t require any special regulation or legislation or stress testing,” Thompson told American Banker.
Those who advocate mandatory stress testing for climate risk say banks simply have not made enough progress on their own. Few banks currently do any scenario analysis for climate change, and when they do, they tend to only examine particular business units, Compere said.
A piecemeal approach means banks may miss other areas of exposure, like in their real estate or auto lending portfolios. Mandating it would ensure consistency, by requiring everybody to test for the same scenarios using the same methodologies.
Advocates also say that investors have a right to know about material risks, which would include both physical and transition risks associated with climate change. And they add that banks mostly already have the tools in place to do scenario analysis.
“Stress testing is neither unusual nor a foreign concept for them,” Lubber said. “The data and the science and the financial risks from climate rise to the level of something that would benefit from a stress test.”
Stress testing for climate risk does not mean a bank has to commit to financing renewable energy or even reduce its financing of fossil fuels and industries heavily reliant on fossil fuels, said Sonia Hierzig, senior projects manager at ShareAction, a nonprofit in London that focuses on responsible investing. But it could eventually pose some hard questions about those types of activities.
“Even if [stress testing] was mandatory, I think there’s a chance the policies would not necessarily improve, by definition,” Hierzig said. “But at least it would make it harder for banks to justify that. Not taking action today is the greatest financial risk.”
