Biden-Harris’s Bank Shot: Financial Institutions, Climate Change and the Coming Regulatory Revolution (Part 1)

This Advisory is the first in a series on ESG considerations for the financial services industry that Arnold & Porter will be publishing over the next several months. While this Advisory focuses on climate-related risk management in the bank supervision context involving banking regulators, it is important to note that other financial regulators, such as the Commodity Futures Trading Commission (and its Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee) and the US Securities and Exchange Commission (and its ESG Subcommittee of the Asset Management Advisory Committee) are also likely to have an active regulatory agenda on climate-related and other ESG matters. One such matter that already has received significant regulatory attention is company disclosure of climate-related and other ESG-related risks. A discussion of ESG disclosures, and what the industry may expect from these other financial regulators on ESG matters under the Biden-Harris Administration, will be the subject of an upcoming Advisory.

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To date, the growing trend in the financial services industry to incorporate environmental, social and governance (ESG) factors into business strategies, risk management frameworks and disclosure practices largely has been a voluntary undertaking. Financial institutions have determined on their own accord that promoting sustainable and socially-conscious business practices is not just good corporate citizenship, it is good business. With respect to one ESG consideration in particular—climate change—a number of financial institutions recently have taken significant steps intended both to support climate resiliency and to mitigate climate-related risks faced by their own institutions. For example, Bank of America announced last week its plan to achieve net zero greenhouse gas (GHG) emissions in its financing, operations, and supply chain by 2050, and net zero GHG emissions in its own operations by 2030.¹ Other large financial institutions, such as HSBC, JP Morgan Chase and Morgan Stanley, have announced similar net zero plans, which are in accord with the goals of the Paris Climate Agreement.²

Notwithstanding such voluntary initiatives, financial institutions can expect increasing regulatory scrutiny and specific climate-related risk requirements and guidance under the Biden-Harris Administration. In his first week in office, President Biden signed an Executive Order³ declaring that "[t]he Federal Government must drive assessment, disclosure, and mitigation of climate pollution and climate-related risks in every sector of our economy."⁴ The Administration already has signaled its intent to carry out this directive in the financial services industry by wielding its regulatory power to ensure that financial institutions are properly accounting for climate-related risks in their business activities. One of the latest signals came on February 12, 2021 when it was reported that Treasury Secretary Janet Yellen is looking to fill a new climate change policy position with Sarah Bloom Raskin, a former senior Treasury official in the Obama Administration and a former Federal Reserve Governor.⁵ Most recently, Raskin has been involved in climate change-related initiatives in the financial services industry. In June 2020, she was a key contributor to a report by Ceres, a group of investors that promotes environmentally-conscious business practices, titled "Addressing Climate as a Systemic Risk: A Call to Action for U.S. Financial Regulators."⁶ The report offered more than 50 recommendations that financial regulators should take to protect the financial system and economy from, in Raskin's words, "potential climate-related shocks that can flatten an economy and grind it to dust."⁷ Secretary Yellen herself also has recently been involved in climate-related issues impacting the financial system. She served as co-chair of the Group of Thirty's (G30) Working Group on Climate Change and Finance, which published a report in October 2020 titled, "Mainstreaming the Transition to a Net Zero-Economy."⁸ The G30 report offered a number of recommendations to governments, financial regulators, and financial institutions. One recommendation to central banks and supervisors was that they "start running regular climate stress tests that are comparable across firms and allow authorities to assess system-wide feedback loops. These tests should consider risks to current balance sheets, as well as the way in which financial institutions may be able to adjust their business model in response to various climate-related scenarios."⁹ Just today—February 18, 2021—Federal Reserve Governor Lael Brainard indicated that the Federal Reserve is considering the use of such climate-risk scenario analyses, stating that they "may be a helpful tool to assess the microprudential and macroprudential implications of climate-related risks under a wide range of assumptions."¹⁰

As discussed below, banking regulators, in particular the Board of Governors of the Federal Reserve System (Federal Reserve) and the New York State Department of Financial Services (DFS), recently have been taking steps to assess climate-related risks both to individual institutions subject to their supervision and to the greater economy and financial system. Under the Biden-Harris Administration, banking regulators are expected to move beyond merely studying climate-related risks and begin issuing specific regulations and guidance that, to at least some degree, financial institutions will have to factor into their business strategies and risk management frameworks. Because of the importance of the issue, and the impact it will have on enterprise-wide operations, boards of directors and senior management are advised to be well aware of the regulatory developments in this area and to take an active role in implementing climate-related measures. In this Advisory, we offer our insight into what the industry may anticipate from the banking regulators in terms of specific requirements and guidance pertaining to climate-related financial risk management.

An Overview of Climate-Related Financial Risk

As an initial matter, it is helpful to understand how banking regulators view climate-related risk, and the impact it may have on supervised institutions and the broader financial system and economy. Banking regulators view climate-related risk through two main channels: physical risk and transition risk.

"Physical risk" refers to the uncertain costs and losses resulting from damage to assets or property caused by severe storms, floods and wildfires; rising sea levels; and regularly increasing temperatures. For example, the value of a mortgage portfolio secured by real estate heavily concentrated in a low-lying coastal region may decline rapidly if there is a severe flood. Or, a bank's collateral in agricultural loans may be wiped out after a sustained drought. That crop failure also may cause a disruption in supply chains, another manifestation of physical risk.¹¹ Finally, physical risk also includes a bank's operational risk. A severe hurricane may damage a bank's branches or destroy the bank's servers, leaving the bank unable to continue its business operations.  

"Transition risk" refers to the uncertain timing and magnitude of government policies, technological innovation, and consumer demand that will accelerate the transformation to a lower-carbon economy. This potentially will result in banks and investors holding "stranded assets" (devalued assets resulting from the transition away from high-carbon industry). Transition risk also includes the unexpected costs of reinvesting in a low-carbon economy and the potential for overvalued assets resulting from a low-carbon boom.¹²

No matter how one looks at it, climate-related risks are an inescapable concern for banks. As a senior economic official from the Federal Reserve put it: "The bottom line is that every future scenario includes climate-related financial risk . . .  . A high-carbon scenario would generate considerable physical financial risk from uncertain extreme events and adverse trends. A low-carbon path would moderate such climate hazards but produce transition financial risk from the possible adoption of new climate policies and technology."¹³        

The Federal Reserve's Climate-Related Initiatives

The Federal Reserve has not yet issued any regulation or guidance specific to climate-related risk management. (Nor has any other federal banking regulator.) As indicated by a series of recent statements and speeches, however, that is likely to change in the Biden-Harris Administration. In November 2020, the Federal Reserve acknowledged climate risk for the first time in its Financial Stability Report, stating that "climate change . . . is likely to increase financial shocks and financial system vulnerabilities," and suggesting that certain policies could moderate these vulnerabilities.¹⁴ In a December 2020 speech, Federal Reserve Governor Lael Brainard stated that "[s]upervisors are responsible for ensuring that supervised institutions are resilient to all material risks, including those associated with climate change," and they therefore are "working to better understand, measure, and mitigate these risks."¹⁵ Governor Brainard followed that speech with another one today—February 18, 2021—in which she said, "[f]inancial institutions that do not put in place frameworks to measure, monitor, and manage climate-related risks could face outsized losses on climate-sensitive assets caused by environmental shifts, by a disorderly transition to a low-carbon economy, or by a combination of both."¹⁶

In one of its most recent signals that it intends to play a major role in addressing climate-related impacts to the financial system, the Federal Reserve announced on January 25, 2021 the creation of a Supervision Climate Committee (SCC). The current stated mission of the SCC is that it will build the Federal Reserve's "capacity to understand the potential implications of climate change for financial institutions, infrastructure, and markets."¹⁷ It is likely, however, that the SCC will have a greater role than merely furthering the Federal Reserve's "understanding" of climate risk.¹⁸ The Federal Reserve named Kevin Stiroh, former Head of the Supervision Group at the Federal Reserve Bank of New York, to lead the SCC. Stiroh has been actively involved in climate risk work and is the co-chair of the Task Force on Climate-related Financial Risks (TFCR) of the Basel Committee on Banking Supervision (Basel Committee). He has given a number of recent speeches that reflect an intent to address climate risk in the financial system aggressively (though methodically) and with innovative approaches.¹⁹

In a March 2020 speech, Stiroh identified certain climate-related measures that some large financial institutions already have taken, as well as some measures that have not been taken.²⁰ While he was not necessarily citing any measure with approval, or lack of measure with disapproval, his references may provide insight into the type of risk management that the Federal Reserve may soon start explicitly expecting from at least its larger supervised institutions. In that speech, he noted four categories of steps that some firms already have considered or adopted:

• Corporate Governance: some institutions had established working groups to develop climate-related frameworks "to ensure climate considerations such as geographic concentrations or regulatory changes are better integrated into strategic decision-making." At most institutions, however, detailed climate reporting was not flowing to boards of directors.
• Risk Identification: certain institutions had conducted periodic disruption simulations with predictive weather modeling. In terms of credit or market risk, some institutions had been considering, for example, heightened monitoring of mortgage concentrations in vulnerable areas and modifying risk limits for transactions to certain carbon-intensive sectors.
• Scenario Analysis: multiple firms had been stress testing physical risk and transition risk scenarios.
• Transparency: nearly all the global systemically important banks, including all eight in the US, had signed onto the Task-Force for Climate-Related Financial Disclosures (TCFD) and had, to varying degrees, begun disclosing under the TCFD framework, which, in general terms, includes disclosures of an institution's climate-related governance, risks and opportunities, and risk assessment and risk management.²¹

Learning from International Banking Regulators and Financial Bodies

It is possible that the Federal Reserve and other banking regulators may look to their European counterparts, particularly the European Central Bank (ECB), which has been at the forefront of climate-related financial supervision. In November 2020, the ECB published its "Guide on Climate-Related and Environmental Risks: Supervisory Expectations Relating to Risk Management and Disclosure," which set forth the ECB's specific expectations for financial institutions considering climate-related and environmental risks in formulating their business strategy and corporate governance and risk management frameworks.²² Among the expectations the ECB places on its supervised institutions are:

• To understand the short, medium, and long term impact of climate-related risks on the business environment in which they operate.
• For the management body to consider climate-related risks when developing the institution's overall business strategy and risk management framework, and to exercise effective oversight of climate-related risks.
• To explicitly include climate-related risks in their risk appetite framework.
• To assign responsibility for the management of climate-related risks in accordance with the three lines of defense model (management controls, compliance, audit).
• Consider and monitor climate-related risk in granting credit and monitoring portfolio risk.
• Consider how climate-related events could adversely impact business continuity and the extent to which the nature of their activities could increase reputational and/or liability risks.
• To assess whether material climate-related risks could cause net cash outflows or depletion of liquidity buffers and, if so, incorporate these factors into their liquidity risk management and liquidity buffer calibration.
• For the purposes of their regulatory disclosures, to publish meaningful information and key metrics on climate-related risks they deem to be material.

Notably, the ECB also expects institutions to monitor the effect of climate-related factors on their current market risk positions and future investments, and to develop stress tests that incorporate climate-related risks.

The US banking regulators also may seek to learn from the Bank of England's (BoE) Climate Biennial Exploratory Scenario (CBES) that is scheduled to launch in June 2021.²³ Indeed, Governor Brainard stated on February 18, 2021 that the Federal Reserve is "closely following the climate scenarios being developed by other central banks."²⁴ Under the CBES, certain of the UK's largest financial institutions will conduct an intensive climate-related stress test. Participating financial institutions, will have to conduct, among other things, counterparty risk assessments that will include collecting and assessing how their counterparties would be positioned in light of underlying climate-related risks and opportunities, as well as assessing corporate counterparties' climate-related risk management plans.²⁵ This counterparty assessment will not include the financial institution's trading risk. Given the dynamic nature of trading books, balance sheet exposures will have limited relevance to the CBES's long-range climate scenarios. The BoE has noted, however, that it may include trading risk in future climate-focused stress tests.²⁶

Of course, given that Stiroh is the co-chair of the Basel Committee's TCFR, the Federal Reserve may look to that group's climate-related developments. As a first step, the TCFR currently is researching and analyzing climate risk transmission channels (i.e., how physical, transition and liability risk manifest into actual loss). The TCFR expects to complete its first phase in mid-2021, after which it will identify effective supervisory practices to mitigate climate-related risk.²⁷

The TCFR and the US banking regulators may build off of the assessment of climate risk transmission channels conducted by the Financial Stability Board. In a November 2020 report, the FSB concluded that the manifestation of the physical risks detailed in the report "could lead to a sharp fall in asset prices and increase in uncertainty," which could have a destabilizing effect on the financial system.²⁸ The FSB also concluded that "[a] disorderly transition to a low carbon economy," which "could be brought about by an abrupt change in (actual or expected) public policy not anticipated by market participants," also could destabilize the financial system.²⁹ The FSB suggested practices currently employed by some financial institutions that "might go some way towards limiting firms' exposures" to climate-related risks. Among those practices are: heightened due diligence on or exclusion policies for lending to, investing in, or underwriting industries with high exposure to climate-related risks; using a specific climate-risk score as a tool to support investment decisions and portfolio allocation; and placing accountability and management responsibility of climate-related risks with the board of directors and/or senior management.³⁰,³¹

New York State DFS's Climate-Related Initiatives

The DFS also is considering how to integrate climate-related risks into its supervisory mandate. While it is doing so, DFS—unlike its federal counterparts—has issued climate-related risk management expectations for its supervised institutions, albeit in rather general terms. On October 29, 2020, DFS issued an Industry Letter stating that it expects its supervised institutions to "start integrating the financial risks from climate change into their governance frameworks, risk management processes, and business strategies."³² DFS also clearly signaled the importance with which institutions must take this guidance, suggesting that institutions designate a board member, a committee of the board (or an equivalent function), and a senior management function that will be accountable for the organization's climate-related risk assessment and management, including the impact on credit, market, liquidity, operational, reputational and strategy risk. DFS also stated its expectation that institutions begin developing their approach to climate-related financial risk disclosures and consider engaging with the TCFD and other similar, established initiatives.  

In another recent signaling of its focus on the financial services sector's climate-related activities, on February 9, 2021, DFS issued another Industry Letter announcing that all institutions subject to the New York Community Reinvestment Act (NY CRA) "may receive credit for financing activities that reduce or prevent the emission of greenhouse gases that cause climate change (climate mitigation), and adapt to life in a changing climate (climate adaptation)," in low- and moderate- income (LMI) communities.³³ DFS-supervised institutions may qualify for NY CRA credit for financing for certain projects including, for example: renewable energy projects for affordable housing to reduce utility payments for LMI tenants and flood resilience projects for multi-family buildings offering affordable housing.

California Legislation

Other states are also looking to regulate climate risk for financial institutions. On February 16, 2021, California legislators introduced a proposed law that would require banks and other financial institutions to prepare an annual climate-related risk report, to be submitted to the State and published on the financial institution's website, by January 1, 2023. The Governor would also be obligated, under the proposed law, to set up an advisory Climate Change Financial Risk Task Force, with members from state financial regulatory agencies to evaluate climate-related financial risk and prepare an annual report.³⁴

Conclusion

While much is still unknown about what the future holds for climate-related regulations and supervisory expectations, banks must not delay in incorporating climate risk into their enterprise-wide risk assessments and risk mitigation frameworks. As discussed, DFS has already published supervisory expectations. And while the Federal Reserve and the other federal banking regulators have not yet released specific supervisory expectations, the Federal Reserve recently stated that climate-related risk is part of a supervised institution's overall risk management, emphasizing that its supervisors "expect banks to have systems in place that appropriately identify, measure, control, and monitor all of their material risks, which for many banks are likely to extend to climate risks."³⁵ The Federal Reserve and DFS have acknowledged that identifying climate-related risk is a difficult task. As Governor Brainard pointed out in her December 2020 speech, assessing an institution's climate-related risk is hampered by data gaps that, for now, are reasonable. (For example, an institution may not know the precise location of its counterparty's assets or, even if it did, the local weather patterns in that location.)³⁶ Nevertheless, it is not certain how long banking regulators will remain understanding of such data gaps. If banks have not done so already, they should promptly begin a serious consideration of their climate-related risk assessment and risk management approaches, taking into account—on a risk basis—the factors discussed above.

Arnold & Porter's Financial Services and Securities Groups have partnered with our Environmental Practice Group to monitor ESG developments in the financial services sector and to develop best practices for the firm's financial institution clients. If financial institutions are seeking advice on how to incorporate ESG factors—including climate-related factors—into their business strategy, risk management or disclosure processes, please contact any author of this Advisory, or your regular Arnold & Porter contact.

© Arnold & Porter Kaye Scholer LLP 2021 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.