How the Banking Sector is Managing Climate Change Risk

Boards and management of financial institutions are “increasingly attuned” to the risks of climate change but their actions and processes vary widely, according to Kevin Stiroh, executive vice president of the Federal Reserve Bank of New York.

In a speech to a conference hosted by Harvard Business School last week, Stiroh outlined the varying approaches to risk assessment and mitigation being taken by banks and other financial services firms in relation to climate change.

Pressure from stakeholders was pushing boards and senior management to take climate risks more seriously, he said, with some companies setting up internal climate-related working groups to formulate responses and integrate risks into strategic decision making.

“Few firms, however, have formally modified or qualified enterprise-wide risk appetite statements to acknowledge climate to date, although some are considering this,” Stiroh said. “Based on our observations, information flows and detailed climate reporting appear more prevalent at the management committee level rather than boards of directors.”

Stiroh also explained how some banks and lenders were adopting climate risk measures into their assessments of exposures and loss estimates. He cited examples such as companies improving the monitoring of mortgage concentrations in high-risk areas, adapting risk limits and adjusting exposures to carbon-intensive industries.

“Climate-related scenario analysis is an emerging practice at multiple firms to identify lending portfolio sensitivity to both physical and transition risks,” he continued. “For physical risk scenarios, this might include stressing mortgage lending in discrete geographies against both publicly available natural hazard scenarios and internally generated severe weather simulations.

“For transition risk scenarios, some firms are using their energy lending portfolios as a starting point to model transition mechanisms. Additionally, some firms are considering how to expand analysis to more indirectly impacted sectors, such as transportation and industrials, or to move beyond lending exposures to trading positions.”

Another important element of financial institutions’ work on climate risk was public disclosure, Stiroh explained. Most global systemically important banks have signed up to the Taskforce for Climate-Related Financial Disclosures (TCFD), he said, with the new reporting standards starting to take effect already.

Last month the TCFD reported that 1,000 global organizations had declared support for the taskforce’s recommendations, which aim to provide consistent climate-related financial disclosures for use by companies in providing information to lenders, insurers, investors and other stakeholders.

Stiroh added: “Firms continue to be challenged in the identification and measurement of climate risk embedded in their portfolios, however, so these disclosures may take some time to develop as the industry considers how to establish common standards.”

On the regulatory side, Stiroh – who was speaking in a personal capacity – said bank supervision “should focus on ensuring that appropriate risk management frameworks are in place, rather than using supervisory tools for broader objectives”.

This meant that regulators should identify and manage risks at microprudential and macroprudential levels as the financial sector transitions to a more sustainable economy.

“Bank supervisors, however, are not in the position to advocate for, or provide incentives for, a particular policy outcome,” he said. “Those broader policy goals are the purview of elected officials and governments, and policymakers.”

Regulators faced challenges in prioritizing long-term risks such as climate change with shorter-term, more immediate risks such as cybersecurity and geopolitical uncertainty, Stiroh said, which had caused some to question why regulatory focus had shifted to risks that will play out over many years.

However, Stiroh explained that the impacts of climate change on financial firms were already becoming evident. In addition, more and more investors considered assessment of sustainability to be “integral” to fiduciary responsibilities.

“This is a risk management question for today with direct implications for safety and soundness,” he said. “Given the complexity of the problem, we all need time to build data, models, and intellectual capacity to address risks as they arise in the future.

“It took the better part of a decade to approach a steady-state in central bank stress testing capabilities for more familiar and arguably less complex risks like credit card losses or shocks to asset values from interest rate spikes. The economics of climate change are more complex with feedback effects, non-linearities and massive uncertainty that will require substantial investments to understand.”