Michael Hsu, Office of the Comptroller of Currency’s (OCC) acting comptroller, addressed the risk climate change poses to banks.
During his remarks at OCC headquarters, Hsu said the OCC will be issuing high level framework guidance for large banks on climate risk management by the end of this year. This announcement followed a recent meeting in Glasgow, Scotland of 100 central banks and supervisors known as the Network for Greening the Financial Systems, where they declared a commitment to action.
“These words are extremely important,” Hsu said. “Bank action is even more so.”
Hsu outlined five questions large bank boards of directors should ask to promote and accelerate improvements in climate risk management practices.
- What is our overall exposure to climate change?
- Which counterparties, sectors, or locales warrant our heightened attention and focus?
- How exposed are we to a carbon tax?
- How vulnerable are our data centers and other critical services to extreme weather?
- What can we do to position ourselves to seize opportunities from climate change?
“Bank boards have a critical role to play in turning words into action and, in doing so, can be a strong force for good,” the acting comptroller said. “In board meetings, the questions that directors ask senior managers can shift bank priorities, reveal hidden strengths, expose fatal weaknesses, and spur needed changes. The most influential board members – the ones who are highly effective in moving the needle and driving change – tend to ask the most probing questions and expect the most of their management team.”
To determine the overall exposure a bank has to climate change, bank senior managers will need to develop a framework, a risk taxonomy, metrics, data, scenarios, and a strong understanding of first- and second-order impacts that physical and transition risk may have on a bank’s portfolio. To determine whether the overall risk is manageable, banks then will need to create a suite of data points to capture the profile of its exposure to climate change risk.
Hsu recommended blending the top-down and the bottom-up approach to assess a banks’ exposure to climate change, a change from what has traditionally been solely a top-down approach. While larger preparations are made for macro approaches to stress testing, he suggested banks also look into smaller scenario testing that directly affects parts of a bank’s portfolio.
These analyses should be developed quickly, and soon. The cost of weather and climate disasters is increasing along with the frequency of such events. Since the beginning of 2017, the total cost of such occurrences has exceeded $690 billion, a record over any five-year period, and this will be the seventh consecutive year the U.S. has experienced 10ormore-billion-dollar weather disasters.
“Understanding one’s exposure to a given risk is foundational to monitoring and managing that risk effectively,” Hsu said. “By posing this question about climate change exposure directly and repeatedly to senior managers, boards will compel and support them in developing the frameworks, gathering the data, and building the teams and systems necessary to effectively manage risks from climate change.”
The second question from above relates to how climate change is going to affect the creditworthiness of some borrowers and sectors. Both physical risks, such as the increased frequency and severity of extreme weather, and transition risks, such as the adjustment to a low-carbon economy and changes in government policy, can affect a borrower’s solvency and the value of their underlying assets.
Identifying those borrowers and sectors most likely to see deterioration, Hsu said, is a critical first step to prudently managing climate risk. It is also important to keep in mind the threat of certain physical risks may also have a disproportionate impact on certain local economies. Similarly, other communities will be more vulnerable to transition risks than others.
Hsu said directors should ask specifically about carbon tax because it can be thought of the transition risk equivalent of the a “severely adverse” scenario.
“It is a way to flesh out, at the aggregate level, the most significant exposures, the biggest concentrations of risk, and the most highly correlated positions,” he said. “More important than the estimate itself, the exercise of coming up with a number will require processes, data, and calculations that will strengthen transition risk measurement practices more broadly. Those capabilities may, in turn, enable more refined assessments of more complex and more likely transition risks in the future.”
Banks also need to consider the vulnerability of their data centers and other critical services to extreme weather. Many large banking institutions heavily rely on data centers to store, aggregate, process, and synthesize data, and some of these centers may be located in areas more likely to be impacted by extreme weather such as storms, tornadoes, and flooding.
Additionally, banks are increasingly dependent on third-party vendors for critical services, and those providers may also be vulnerable to climate change and could affect a bank’s ability to continue critical operations. Knowing what these vulnerabilities are is a critical part of continuity and disaster planning.
“It is important to remember that climate change presents opportunities, as well as risks” Hsu said. “Banks that are poorly prepared to identify climate risks will be at a competitive disadvantage to their better-prepared peers in seizing those opportunities when they arise…. Banks with strong climate risk management systems and capabilities will not only be better prepared to withstand climate change events but will also have a better line of sight into the many business opportunities that will arise.
“Just as strong credit risk management capabilities can provide the assurance and confidence needed for a bank to make risky credit decisions prudently, strong climate risk management capabilities can enable the same prudent risk taking with regards to climate-related business opportunities.”