Regulators Finalize Framework for How Banks Should Address Climate Related Financial Risk

On Tuesday, October 24, 2023, the Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve System (FRB), and Office of the Comptroller of the Currency (OCC) published a finalized framework that outlines how financial institutions should manage and plan for potential climate-related financial risk.

This latest guidance is similar to proposals issued by each of these agencies in December 2021, April 2022, and December 2022, respectively. The regulators jointly published these finalized principles in an attempt to promote consistency in guidance and incorporate public feedback. The framework is designed to support the efforts of financial institutions with more than $100 billion in total consolidated assets to better identify and manage climate-related financial risks.

Summary

The framework examines both the physical and transitional risks associated with climate change and outlines how financial institutions can manage this risk through (1) Governance, (2) Policies, Procedures, and Limits, (3) Strategic Planning, (4) Risk Management, (5) Data, Risk Measurement, and Reporting, and (6) Scenario Analysis.¹ Specifically:

Governance — Banks need effective risk governance frameworks, and management teams should understand climate-related financial risk. This includes allocating appropriate resources, assigning climate-related financial risk roles and responsibilities throughout the organization (e.g., committees and reporting lines), reviewing necessary information to oversee the bank (e.g., strategic planning, internal audit), and clearly communicating to staff the climate-related impacts to the bank’s risk profile.
Policies, Procedures, and Limits — The bank’s approach to risk management policies, procedures, and limits should include climate-related risks and be monitored and modified as necessary.
Strategic Planning — The bank’s overall business strategy, risk appetite, and financial, capital, and operational plans can be impacted by climate-related financial risk. It can impact the bank’s business objectives, stakeholders’ expectations, the bank’s reputation, operations, financial condition, as well as low-to-moderate income  and other disadvantaged households and communities.
Risk Management — The bank should have sound processes to identify, measure, monitor, report, and control climate-related financial risk exposures within the bank’s existing risk management framework. Banks should constantly review emerging risks stemming from business activities and other exposures. These risks must be clearly defined within the risk management framework and supported by appropriate metrics.
Data, Risk Measurement, and Reporting —  Banks should have access to relevant, accurate, and timely data when analyzing climate-related financial risk. Further, climate-related financial risk information should be built into internal reporting, monitoring, and escalation processes. Accurate and timely information allows management teams to make educated decisions when assessing the impact climate-related financial risk would have on their bank.
Scenario Analysis — The principles refer to climate-related scenario analysis as “exercises used to conduct a forward-looking assessment of the potential impact on a bank of changes in the economy, financial system, or the distribution of physical hazards resulting from climate-related risks.”² These exercises assess and provide a comprehensive and forward-looking perspective to structural changes arising from climate-related risks. A scenario analysis could help by:

• Exploring the impacts of climate-related risks on a strategy and business model
• Identifying and measuring vulnerability to physical and transition risks
• Estimating climate-related exposure and potential losses for multiple scenarios
• Assisting in identifying data and methodological limitations and uncertainty in climate risk management
• Informing the adequacy of the bank’s climate risk management framework

Furthermore, the principles are designed to assist banks with improving their risk governance framework. The framework provides support to banks identifying emerging climate-related risks and implementing appropriate strategies to mitigate those risks. The guidance highlights six areas of climate-related financial risk to consider: Credit, Liquidity, Financial, Operational, Legal/Compliance, and Non-Financial (e.g., strategic decisions). 

As a result of feedback shared on the previously proposed guidance, these principles clearly articulate that institutions are not prohibited from providing “banking services to customers of any specific class or type, as permitted by law or regulation.”³ Additional modifications to this guidance include “clarification on the applicability to large foreign banking organizations, clarification on the role of boards of directors and management, and the removal of a reference in the FRB’s proposal to compensation practices.”⁴

Key Considerations

While this framework is focused on financial institutions with more than $100 billion in assets, all financial institutions should consider aligning their organizations to it and make the changes necessary to ensure they are well-positioned to manage climate-related risk. Entities should consider proactively assessing their exposure based on these principles and review the areas of risk as they relate to the entities’ existing risk management framework and business strategy. This includes identifying and assessing any climate-related enterprise risks not included in their current frameworks that could impact their overall business strategy, risk appetite, and capital plan.

This framework is consistent with the law recently passed in California (SB 261, the Climate-Related Financial Risk Act) that will apply to public and private companies, including financial institutions, with more than $500 million in revenue that do business in CA. The framework is also consistent with the disclosure requirements of the International Financial Reporting Standards in their Climate-Related Disclosures Standard.

How Guidehouse Can Help

Guidehouse can support financial institutions and management teams in assessing their risk management frameworks as a result of this newly published guidance by the FDIC, FRB, and OCC. Guidehouse has a deep bench of financial services and climate and energy professionals with decades of commercial and public sector experience and a strong understanding of the climate environment in which financial institutions operate. Among other capabilities, Guidehouse can quickly review and assess your risk management framework to determine whether it is sound, identify gaps or weaknesses, and provide recommendations to ensure it aligns with the updated guidance. Guidehouse is well-equipped to make an individualized assessment of your unique circumstances and offer innovative advice and solutions for responding to potentially heightened regulatory requirements.

This article was co-authored by Henry Darmstadter and Gabriella Juliana.