By Yevgeny Shrago
On Dec. 16, the Office of the Comptroller of the Currency released draft supervisory guidance for how banks should manage the risks related to climate change. This makes the OCC the first federal regulator to lay out expectations for how banks should incorporate climate-related threats into their governance, planning, and risk management. Not meant to be exhaustive, the guidance is a starting point, providing high-level principles to get banks and their supervisors started on taking climate-related risk seriously. It is an important step in protecting financially vulnerable communities, banks, and the financial system from the effects of climate change.
The OCC plans to issue additional guidance, clarifying specific areas and providing additional detail, as well as best practices and lessons learned.
What does the guidance tell banks to do?
The draft guidance, which is targeted at banks with $100B or more in assets, sets out general principles for how banks should address climate change. Much of this reflects global best practices recommended by bodies like the Network for Greening the Financial System, a consortium of central banks, and adopted by leading banking regulators like the European Central Bank.
Climate Risk as Safety and Soundness Risk. The OCC identifies climate risk as a threat to a bank’s safety and soundness and to overall financial stability. The OCC has broad authority to police unsafe and unsound bank practices, and impose remedies, including requiring that banks hold additional capital or divest risky assets. By situating climate-related financial risk in this legal framework, the OCC has laid the groundwork for requiring banks to mitigate any such risk that examiners identify as part of the supervisory process. This identification puts both the guidance and any subsequent supervisory action on a very strong legal footing.
Climate-Related Risk is Different from Other Risks. The OCC makes it clear that bank management needs to think differently when managing risks from the climate crisis, and provides specific examples that will help keep banks on sound footing:
- It tells leadership to think about the risks of climate change along time horizons longer than the usual 3-5 year strategic planning horizon that banks use. The OCC specifically highlights the value of scenario analysis and tells banks to develop frameworks for conducting that analysis. This is important because the likelihood of climate-driven harms manifesting is highly uncertain over a short time horizon, but becomes more certain over the longer time frame.
- It recommends that banks modify their risk limits and change their activities to reflect the distinctive characteristics of climate-related risks.
- It recognizes that climate risk is not perfectly understood, and tells banks to incorporate climate-related risks in an iterative process, updating their models and data as methods improve over time.
- It warns that banks should analyze and monitor concentrations of both physical and transition risk in sectors, geographies, and individual counterparties. This is particularly important because, as the OCC says, climate change can create correlated risks across different kinds of exposures and asset classes. Importantly, the guidance directs banks to determine lending limits related to the risk of correlated, concentrated exposures.
Managing Climate-Related Risk Raises Fair Lending Concerns. The OCC warns banks to consider the fair lending implications of managing climate-related risk.
- In particular, it lays out a disparate impact standard, highlighting possible fair lending concerns if a bank’s risk mitigation measures disproportionately affect communities based on illegal considerations, like race, regardless of intent.
- It also cautions banks to avoid disproportionate impacts on other financially vulnerable communities, and states that banks need additional guidance on avoiding this risk.
Climate-Related Risk Has a Broad Set of Impacts and Requires a Whole of Business Management Approach. The OCC recognizes that climate risk is not a narrow risk but one that can affect a bank in many ways. As a result, the OCC’s expectations call on banks to:
- Incorporate climate-related risk management into every level of their business, starting from the board and senior management. Notably, the OCC specifically highlights the importance of incorporating climate risk into the bank’s internal control, including internal audit, in the risk management framework. This means banks need to develop policies and procedures and assign personnel specifically to identify and limit the climate risk that they take on, and to monitor any weaknesses in the way that the bank takes on climate risk.
- Develop a comprehensive process for managing climate-related risk exposures, including by developing clear definitions of what possible exposures are, and metrics for setting limits and measuring exposures.
- Consider and incorporate climate-related risks when identifying all kinds of risks. This means the OCC will need to incorporate consideration of climate risk into its supervisory ratings, which measure how well banks are managing different types of risks and consider climate-related risk when assessing asset quality.
Holding Banks to their Climate Commitments. The OCC tells banks that where they publicly communicate their climate-related strategies, boards and management must make sure those commitments are consistent with their internal strategies. Many banks have made broad climate commitments even as they continue making loans and investments that are incompatible with those commitments. This guidance would limit that practice and strengthen the case of those in banks who want to actually shift business strategy to align with stated climate targets.