U.S. banking regulators taking harder look at climate change

Once content to sit on the sidelines of the climate-change fight, U.S. banking regulators have begun to speak out about the connections between extreme weather and the financial system.

The Federal Reserve Bank of San Francisco has mostly led the charge, but in recent weeks top officials at the New York Fed and the Federal Reserve Board have joined the conversation. They have focused largely on encouraging the private sector to think about the broad systemic risks of changing weather patterns, in some cases issuing calls for innovation to deal with certain threats.

The recent remarks raise several questions. For starters: Why now? Do the comments foreshadow new regulatory requirements on the horizon? And do regulators need to better coordinate their messages?

Mounting losses from hurricanes, floods and wildfires have finally become too great for banking regulators to ignore, industry observers said. One major example they cite is the bankruptcy of PG&E, which lost over $20 billion from the deadly California wildfires of 2017 and 2018. PG&E’s bankruptcy filing is the largest corporate bankruptcy in the U.S. in the past decade and perhaps the first that can be linked directly to climate change.

“We are on the verge of the economic implications of climate [change] being seen for exactly what they are: formal, systemic financial risks that need to be factored into financial decisions,” said Mindy Lubber, president and CEO of the nonprofit Ceres, which consults with companies about sustainability issues.

U.S. banking regulators have largely trailed their European counterparts in addressing the risks that climate change poses to the financial system. Central banks abroad have already been assessing the economic impacts of a warming world, and the Bank of England is even considering incorporating climate risk into its analyses of banks’ loan portfolios.

In letters to Congress in March and April, the three federal banking regulators signaled that they weren’t willing to go as far as incorporating climate risk into stress testing. But various remarks and proposals since then, especially from regional Fed officials, indicate that regulators’ views are evolving quickly.

Kevin Stiroh, an executive vice president with the New York Fed, recently highlighted climate change as a major emerging risk to the U.S. economy during remarks at the GARP Global Risk Forum. He pointed out, for example, that the U.S. has lost $500 billion over the past five years due to climate-related events.

“Climate change has significant consequences for the U.S. economy and financial sector through slowing productivity growth, asset revaluations and sectoral reallocations of business activity,” he said Nov. 7.

Just days later, the San Francisco Fed hosted a daylong conference dedicated to the issue, a first for any U.S. banking regulator.

“It is vital for monetary policymakers to understand the nature of climate disturbances to the economy, as well as their likely persistence and breadth, in order to respond effectively,” Fed Gov. Lael Brainard said in prepared remarks at the event.

The San Francisco Fed in October published its annual Community Development Innovation Review, focusing this year almost exclusively on the various economic challenges posed by increasingly severe weather patterns. One example of a challenge for lenders will be climate-induced migration.

As increasingly severe storms batter coastal areas, repeat flooding will drive down property values and render homes uninhabitable and uninsurable, according to an article in the review. People of means will move away, but low- and moderate-income homeowners will have considerably fewer options. Some will default on their mortgages, leaving banks with assets that are essentially worthless. At some point, banks will no longer be able to justify lending in those areas.

Lenders should think now about how they are going to deal with that issue, two climate researchers — A.R. Siders and Carri Hulet — wrote in that article. One potential solution could be to transfer mortgages from properties in at-risk areas to foreclosed properties in safer areas that the borrowers could relocate to, they said.

Economists with the San Francisco Fed have also suggested banks could earn Community Reinvestment Act credit by investing in projects that fortify low- and moderate-income communities against climate disasters.

The Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency have been relatively quiet on the issue. But Comptroller of the Currency Joseph Otting said at an industry event on Nov. 12 that while the agency hasn’t taken a position on climate change, “we’re definitely talking about it with the financial institutions that we regulate.”

But the shift in tone does not necessarily mean new rules are on the way. Regulators are paying attention to wider discussions around climate change and putting it on banks’ radar as another risk factor, industry observers say. The conversation is only just beginning in the U.S., according to the observers.

“Ultimately, for some of the other regulatory bodies to start to engage in the ways they’re doing in Europe, that’s probably going to take leadership from the top, whether it be the administration or Congress,” said Ivan Frishberg, director of impact policy at the $5 billion-asset Amalgamated Bank. “It’s appropriate that this conversation is beginning with the Federal Reserve System.”

Mark Watson, managing director at Ernst & Young, said the increased regulatory emphasis is at least part of the reason more financial institutions are incorporating the climate threat into their own risk management framework.

“It’s feeling very real now as a risk that needs to be identified, measured, managed and reacted to,” he said. “I think more and more regulators are going to focus on this, and that’s why some institutions are taking a lead on this.”

According to a recent risk management study by EY, 52% of banks surveyed ranked climate change as a key emerging risk in the next five years, compared with just 37% last year. Among North American banks specifically, 48% said they consider climate change to be an emerging risk.

“It feels very palpable. It feels palpable to customers of banks, to employees of banks, to banks’ clients,” Watson said of the shift in opinion. “It’s not like the weather suddenly changed, but extreme weather does feel much different now than it did two or three years ago.”