Is the Sky Really Falling? Acting Comptroller Proposes Key Questions for Banks on Climate Change
- In a speech at the Office of the Comptroller of the Currency (OCC) headquarters on Nov. 8, 2021, Acting Comptroller of the Currency Michael J. Hsu proposed some of the most sweeping regulatory proposals on banking and climate change yet.
- Hsu has set forth a framework for bank boards and examiners to assess a bank's readiness to adapt to climate change, which represents a potentially substantial – even if viewed by many as environmentally necessary – regulatory burden.
- The message to the industry is clear: climate change must become a factor in banks' decision-making processes, and at a minimum, bank boards should start the conversation about how to integrate some of the OCC's suggestions into their operations.
Canadian singer-songwriter Joni Mitchell lamented the toil of deforestation in 1970: "They took all the trees, put 'em in a tree museum/And they charged the people a dollar and a half just to see 'em." More than 50 years after her environmental anthem, another voice of environmental awareness would ring out from a source that Mitchell could never have imagined in 1970: a federal banking regulator in Washington, D.C., who also laments the crisis of climate change with a voice that is posed to change the national discussion on climate awareness and action.
On Nov. 8, 2021, Acting Comptroller of the Currency Michael J. Hsu, in a speech at the Office of the Comptroller of the Currency (OCC) headquarters, proposed some of the most sweeping regulatory proposals on banking and climate change yet. Framed as "Five Climate Questions Every Bank Board Should Ask," the Acting Comptroller has set forth a framework for bank boards and examiners to assess a bank's readiness to adapt to climate change as well as the bank's own risk assessment of the impact of climate change on its operations, vendor operations and borrowers' risk. Assuming that the framework set forth in this speech is eventually more formalized into agency guidance or even regulations, it represents a potentially substantial, even if environmentally necessary, regulatory burden.
Acting Comptroller Hsu's questions address several different aspects of banking operations from macroeconomic issues to counterparty risk, bank-specific concerns and more.
Question No. 1: What Is Our Overall Exposure to Climate Change?
In order to respond to this question, the OCC suggests that bank managers "need to develop a framework, a risk taxonomy, metrics, data, scenarios, and a strong understanding of the first- and second-order impacts that physical and transition risks may have on the bank's portfolio." Moreover, "Understanding one's exposure to a given risk is foundational to monitoring and managing that risk effectively. 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 question calls on banks to develop an enterprise-wide framework for evaluating climate change exposure. The OCC may look for banks to take such steps as appointing a chief climate change risk officer as the OCC did in July 2021. The OCC may also expect banks to have periodic presentations to the board of directors as to the impact of climate change on the bank.
Question No. 2: Which Counterparties, Sectors or Localities Warrant Our Heightened Attention and Focus?
In this question, the OCC is tying climate change to counterparty risk, noting explicitly that "Climate change is going to significantly impact the creditworthiness of some borrowers and sectors." The OCC identifies two types of risks that banks should consider: physical risk and transition risks. Physical risks include the increased frequency, severity and volatility of extreme weather and long-term shifts in global weather patterns and their associated impact on the value of financial assets and borrowers' creditworthiness. Transition risks relate to the adjustment to a low-carbon economy and include associated changes from government policy, technology and consumer and investor sentiment.
The counterparty risk assessment goes far beyond abstract, macro notions of global climate change impact. Rather, the Acting Comptroller's statement calls on banks to identify "those borrowers and sectors most likely to see deterioration in their ability to repay or in their collateral values under potential physical and transition risk scenarios [as] a critical first step to prudently managing climate risk" (emphasis added). This call to incorporate climate risk into ability to repay and collateral valuation is potentially a game-changer in the area of lending. This policy may require that banks adopt policies to price credit products higher if the borrower, collateral or industry sector carries greater climate exposure. The OCC may take the view that banks should be doing this already, but requiring it will necessitate a substantial revision to bank credit risk modeling, data collection and underwriting analysis.
Question No. 3: How Exposed Are We to a Carbon Tax?
A carbon tax puts a price on emissions of carbon dioxide and other greenhouse gases, encouraging people, businesses and governments to produce less of them. Even though Acting Comptroller Hsu acknowledges that the U.S. is unlikely to see a carbon tax in the foreseeable future, he views the anticipation of such a tax as "the transition risk equivalent of the 'severely adverse' scenario in CCAR [Comprehensive Capital Analysis and Review]." Further, Acting Comptroller Hsu suggests: "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."
Some banks and analysts may scoff at the idea of using a tax that the OCC acknowledges is very unlikely to materialize as a proxy for transition risk as an unnecessary supervisory burden. Some might argue that it makes as much sense as requiring a bank that only extends loans collateralized for aircraft, watercraft and rolling stock to conduct an assessment of residential real estate market fluctuations; it would have no rational relation to the bank's activities. Nevertheless, the Acting Comptroller sees carbon tax resilience as an appropriate proxy for the "severely adverse" scenario under CCAR.
The OCC's reference to CCAR is particularly notable. The Federal Reserve Board describes CCAR as "an annual exercise by the Federal Reserve to assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress and that they have robust, forward-looking capital-planning processes that account for their unique risks." This may signal a requirement to impose CCAR-like stress testing for a bank's ability to withstand changes in climate-related risk.
Question No. 4: How Vulnerable Are Our Data Centers and Other Critical Services to Extreme Weather?
Business continuity planning (BCP) has long been a focus of supervisory review. According to the OCC in its Nov. 14, 2019, bulletin, "Business continuity management is the process for management to oversee and implement resilience, continuity, and response capabilities to safeguard employees, customers, and products and services. Disruptions such as cyber events, natural disasters, or man-made events can interrupt a bank's operations and can have a broader impact on the financial sector." The Acting Comptroller's question in this area suggests that banks must evaluate the impact of "extreme weather" on a bank's continuity of operations, including bank premises and third-party vendors that the bank relies on for services. According to the Acting Comptroller's speech, "Risk assessments and mitigation that take the full range of climate scenarios into account may prompt consideration of modifications to data center strategies or business continuity plans."
This area would require banks to review, revise and expand the scope of their BCP policies to anticipate disruptions caused by climate change events.
Question No. 5: What Can We Do to Position Ourselves to Seize Opportunities From Climate Change?
Banks will appreciate that not all of Acting Comptroller Hsu's remarks were dark and stormy. In this area, he notes that: "Renewables, carbon capture, electric vehicles, charging stations – these are the most obvious banking opportunities arising from climate change. Changes in agriculture, water infrastructure, consumer preferences, and investor sentiment will also create opportunities." He suggests that "strong climate risk management capabilities can enable the same prudent risk taking with regards to climate-related business opportunities."
This focus area may require banks to reevaluate their investment portfolio and may provide for increased opportunities for joint ventures and community development investments.
How the OCC decides to implement Acting Comptroller Hsu's sweeping climate change supervisory initiative remains to be seen. Codification of the above points in OCC regulations is likely too aggressive and may draw the ire of conservative and moderates in Congress to trigger rescission of any such regulations pursuant to the Congressional Review Act. The more likely approach is for the OCC to issue a supervisory bulletin spelling out the agency's supervisory expectations and incorporate the guidance into OCC examination manuals covering such topics as risk management, BCP, public welfare investments, collateral valuation and others. By incorporating the above points into scattered sections of the OCC's many examination manuals, the OCC would be able to broadly integrate the concepts into the examination process without targeting a single, stand-alone document for industry criticism.
Whatever form the OCC's supervisory approach may take, the message telegraphed to the industry is clear: climate change must become a factor in banks' decision-making processes. At a minimum, bank boards should start the conversation about how to integrate some of the OCC's suggestions into their operations. Of course, the degree of such integration will depend on each bank's own unique risk profile and operations. This may mean starting the conversion at the board level to lay the groundwork for a climate change review working group, identifying partnerships for the bank with other climate change-focused stakeholders to build upon the synergistic opportunities that banks offer, establishing a climate change risk management committee or even just having outside counsel or consultants provide presentations to the board to introduce the issues.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.