Navigating New Principles for Climate-Related Financial Risk Management
U.S. banking regulators have issued a new framework for climate-related risk. What are the core principles, and how should financial institutions respond?
Thursday, January 25, 2024
By Olivia Krylov
Over the past year, significant strides have been made by the U.S. regarding regulations addressing climate-related risks in finance. Notably, in October 2023, the Federal Reserve Board (FRB), the Office of The Comptroller of The Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC)issued a forward-thinking framework that addresses climate-related risks faced by large financial institutions.
This step echoes similar regulatory initiatives in other regions, such as Europe’s guidance on climate-related risks. A 2022 report issued by the Basel Committee on Banking Supervision also addresses the risk that climate concerns could pose to financial institutions, leveraging previous regulatory, supervisory and disclosure initiatives.This report identifies potential gaps in the Basel framework and considers measures to address them, and the new U.S. framework presents a similar gap analysis.
Having initially released similarly climate-focused regulations independently, the FRB, OCC and FDIC combined their efforts to produce new guidelines through the Principles for Climate-Related Financial Risk Management (PCRFRM), aimed at mitigating climate-related risks for large firms with over USD 100 billion in total assets. This new high-level framework is intended to identify, measure, monitor and control both physical and transition risks since financial institutions are likely to be affected by both.
An Overview of the Core Principles
The guidelines are divided into six principles, which are examined below. The broad goal of climate-related financial risk management is broken down into strategic actions, and the appropriate roles of boards and management are clarified so that existing governance standards are applied to climate risks.
While this framework is focused on firms with assets over USD100 billion, both large and small firms alike may eventually be impacted by these new guidelines.
Governance: The boards of institutions should understand the effects of climate-related risks on their business strategy and incorporate them into their risk profiles. Governance should involve the development of processes that will identify, measure, monitor and account for climate-related financial risks within the institution's risk management framework. The final element of this principle includes management’s responsibility for regularly reporting the severity and nature of climate-related financial risks to the board.
Policies, Procedures and Limits: Policies and their implementation should reflect the different aspects of climate-related risk, such as considering a longer time horizon. This also may require changes to the institutions' operating environments and/or activities.
Strategic Planning: Material climate-related risk exposures in the creation and adjustment of business strategies, risk appetites and capital plans also need to be taken into consideration. Strategic plans must address the potential impact of risk exposures to the institution, especially in geographies that may be disproportionately affected by climate-related risks.
Additionally, a strategy should encompass the financial risk impact on stakeholders who might be adversely affected (for example, low-income or disadvantaged communities). Lastly, this guideline combats some greenwashing concerns by addressing public statements about institutions’ climate-related strategies and how their commitments should be consistent with their internal principles.
Risk Management: Management teams are responsible for the implementation of processes to identify, measure, monitor, control and report climate-related risk exposures within the institution's existing risk management framework. Institutions must have a comprehensive risk identification process and tools with appropriate metrics to define material risk exposures. Tools for measuring climate-related financial risks include exposure analysis, heat maps, climate risk dashboards and scenario analysis which can be used to assess exposure risks in both the short and long term.
Data, Risk Measurement and Reporting: Comprehensive risk management depends on timely, accurate, complete and relevant data. Climate-related risk metrics should be incorporated into internal reporting, monitoring and escalation processes to mitigate risk. Data aggregation and reporting allows management to capture material risks and identify the nature of the risk – physical or transition – and its complexity.
Scenario Analysis: This is an approach for identifying, measuring and managing climate-related risks, and differs from traditional stress testing because of the longer timeline and in-depth analysis, commensurate with firm size, complexity, etc. It is a forward-looking assessment of the potential impact of changes in the economy, financial system or physical hazards resulting from climate-related risks. Analysis frameworks should have clear objectives, such as identifying and measuring vulnerability to relevant climate-related financial risk factors, estimating climate-related exposures and potential losses across a range of scenarios.
Climate-Related Risks Need to Be Included in All Relevant Categories
Financial institutions need to include climate-related risks in their risk management frameworks to address these principles and ensure compliance with the PCRFRM framework. The regulation outlines requirements for the following risk categories:
Credit Risk – The process of underwriting and monitoring portfolios should account for climate-related financial risks. Credit risk management practices could include monitoring climate-related credit risks through industry sectoral, geographic and single-name concentration analyses (if they have a material stake allocated to one stakeholder). It is part of management’s responsibility to determine credit risk tolerances and lending limits related to risks.
Liquidity Risk – Financial institutions should assess if climate-related risks could affect an institution's liquidity position and incorporate those risks into their liquidity risk management practices and liquidity buffers.
Other Financial Risk – Financial institutions must monitor interest rates and other inputs for volatility or price risks connected to climate-related risks.
Operational Risk – The impact of risk exposures should be considered in operations, control environment and operational resilience. Risk assessments should be performed across all business lines and operations.
Legal/Compliance Risk – Financial institutions should consider how risks and risk mitigation affect their legal/regulatory landscapes. This includes any changes to legal requirements and disaster related insurance, as well as possible fair lending concerns, if mitigation disproportionately affects certain communities.
Other/Non-Financial Risk – Financial institutions should oversee the impact of strategy execution on their financial health and resilience. They should also consider the extent to which the institution's activities might increase the risk of negative fiscal impact from other operational risks, liability or litigation.
How This Impacts Your Organization
Financial institutions must integrate PCRFRM principles and risk categories into their business strategy and risk architecture, despite challenges stemming from the framework's lack of specificity and confu-sion regarding dependencies between principles.
To ensure adherence to this framework, the first step involves a current state analysis and review of existing policies, procedures, risk management frameworks and business strategies. This analysis should identify gaps, where climate risk isn’t adequately considered, that require attention.
The Data, Risk Measurement and Reporting principle plays a crucial role in an institution’s compliance. Synthesizing this data aids in identifying and defining risks, throughout their processes, with clear met-rics. Informed by climate exposure data as well as risk analysis, large parts of the firm may then need to be mobilized to ensure they are identifying, measuring, monitoring and managing climate-related risks.
OliviaKrylov is an Associate at Capco within the regulatory compliance domain, with a focus on integrating sustainability and Environmental, Social, and Governance (ESG) goals into financial services clients' wider strategic initiatives.