climate change banking regulation

The San Francisco Fed in October published its annual Community Development Innovation Review, focusing this year almost exclusively on the various economic challenges posed by increasingly severe weather patterns. For reprint and licensing requests for this article. Responses to Climate Change and the Central Bank's Mandate From a medium- to long-term perspective, climate change could have an extremely large impact on developments in economic activity and prices as well as financial conditions. Oil and gas, power generation, real estate, automotive, and agriculture present significant green-investment opportunities. At her confirmation hearing, Treasury Secretary Janet Yellen called climate change an “existential threat” and stated that she plans to create a special unit, led by a senior official, to examine the risks that climate change poses to the financial system. One potential solution could be to transfer mortgages from properties in at-risk areas to foreclosed properties in safer areas that the borrowers could relocate to, they said. It feels palpable to customers of banks, to employees of banks, to banks’ clients,” Watson said of the shift in opinion. This article was edited by Richard Bucci, a senior editor in the New York office. People of means will move away, but low- and moderate-income homeowners will have considerably fewer options. Those that make haste, however, increase the risk of missteps. Other climate experts have also criticized the veracity of climate analytics,REF and overreliance on these models and data could seriously misrepresent any climate-related risks. Bank activities are highly regulated by both state and federal regulators, more so than those of most types of nonbank financial firms. Found inside – Page 29Climate mitigation-promoting regulatory tools have been implemented in some countries. Banque du Liban differentiates banks' reserve requirement ratios ... The Biden Administration is actively seeking to fight climate change through financial regulation. The executive order directs various government officials to deliver reports to the President with recommendations for further action by mid-November 2021. Many investors, responding to their clients’ shifting attitudes, already consider environmental, sustainability, and governance (ESG) factors in their investment decisions and are channeling funds to “green” companies. One major example they cite is the bankruptcy of PG&E, which lost over $20 billion from the deadly California wildfires of 2017 and 2018. Central bank officials have started paying increasing attention to the issue of climate change in recent years. 1. In general, federally chartered banks are subject to supervision by the Office of the Comptroller of the Currency (OCC). This is the first book dedicated to the subject of Green Finance, a new dynamic field of modern finance. McKinsey Institute for Black Economic Mobility. Fund management firms are generally compensated from sales commissions (often called loads) and investment management fees are typically based on assets under management. Bundesanstalt für Finanzdienstleistungsaufsicht. “We are on the verge of the economic implications of climate [change] being seen for exactly what they are: formal, systemic financial risks that need to be factored into financial decisions,” said Mindy Lubber, president and CEO of the nonprofit Ceres, which consults with companies about sustainability issues. It is the fifth such transaction announced since Aug. 5 and the 10th of the year. But various remarks and proposals since then, especially from regional Fed officials, indicate that regulators’ views are evolving quickly. Overall, institutional investors control about 71 percent of the shares held in the United States.REF This concentration means that an extremely small group, perhaps as few as 15 to 20 proxy advisory firms and investment fund managers can exercise effective control over most public corporations in the United States. Depending on the specific activity, at least seven federal regulators—(1) the Federal Reserve; (2) the FDIC; (3) the SEC;REF (4) the Commodity Futures Trading Commission (CFTC); (5) the Consumer Financial Protection Bureau (CFPB); (6) the Federal Housing Finance Agency (FHFA); and (7) various agencies within the U.S. Treasury DepartmentREF—could supervise, examine, or otherwise regulate a bank.REF One way to make sense of the massive regulatory framework is to broadly group the regulatory functions as follows: (1) chartering and entry restrictions; (2) regulation and supervision; and (3) examination.REF. Our analysis of portfolios at 46 European banks showed that, at any one time, around 15 percent of them carry increased risk from climate change. In energy, opportunities are present in alternatives, refining, carbon capture, aviation, petrochemicals, and transport. This book details the effects of climate variability on small pelagic fish and their ecosystems and fisheries. The counterparty model was useful to differentiate the climate risk among companies within sectors. The commercial imperatives for better climate-risk management are also increasing. The recommended regulations can be expected to raise costs for both consumers and businesses, create barriers to entry that help large incumbent firms by reducing competition, reduce productivity and competitiveness of U.S. employers, harm wages, and have other adverse social consequences. The seller’s identity is unknown, but the bank’s shareholders include a number of prominent activists. Section 165 of the 2010 Dodd–Frank ActREF requires the Federal Reserve Board of Governors (on its own, or pursuant to recommendations by the FSOC)REF to develop prudential regulatory standards for the nonbank financial firms they supervise as well as bank holding companies with assets equal to or greater than $250 billion. For developing a comprehensive approach to risk management, we see three key steps, which should be attainable in four to six months. The Federal Reserve Bank of New York’s top bank oversight official is leaving the bank and moving to the Washington-based Board of Governors to lead its climate-change … However, the centralization and standardization of how the private sector assesses risk typically does far more harm than good. This is being done under the banner of social justice; corporate social responsibility (CSR); stakeholder theory; environmental, social, and governance (ESG) criteria; socially responsible investing (SRI); sustainability; diversity; business ethics; common-good capitalism; or corporate actual responsibility.REF. Starting in the 1990s, federal banking agencies began to identify “reputational risk” as part of their broader efforts to manage financial institutions’ overall risks.REF Since that time, most federal agencies have clarified their views on reputational risks.REF Subsequently, both the FDIC and the OCC have justified forcing banks to change their operating behavior based on concerns over reputational risk.REF, According to the OCC, “[r]eputation risk is the risk to current or projected financial condition and resilience arising from negative public opinion,” and “[r]eputation risk is inherent in all bank activities.”REF According to the OCC’s examination handbook, examiners now consider a bank’s “quantity of reputation risk and quality of reputation risk management.”REF These risks include many different factors, ranging from the “types of third-party relationships” and the “types of assets” that are under management, to the “market’s or public’s perception of the quality of the bank’s products” and the “market’s or public’s perception of the bank’s financial stability.”REF, Similarly, the Fed’s official guidance states: “Principles of sound management should apply to the entire spectrum of risks facing a banking institution including, but not limited to, credit, market, liquidity, operational, legal, and reputational risk.”REF The Fed defines reputational risk as “the potential that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.”REF (Emphasis added. In 2019, the Fed released its final rule on prudential standards for large bank holding companies.REF This rule, which might provide a clue to how regulators could structure climate-related regulations, establishes “four categories to apply enhanced standards based on indicators designed to measure the risk profile of a banking organization.”REF The categories are essentially based on size, with progressively more stringent requirements applied to the larger banks.REF The most stringent prudential regulations are under Category I, and they are reserved for U.S.-based global systemically important banks (GSIBs). Just days later, the San Francisco Fed hosted a daylong conference dedicated to the issue, a first for any U.S. banking regulator. Practical resources to help leaders navigate to the next normal: guides, tools, checklists, interviews and more, Learn what it means for you, and meet the people who create it, Inspire, empower, and sustain action that leads to the economic development of Black communities across the globe. Updating the cost assumptions for BEIS’s energy efficiency modelling,” UK Department for Business, Energy & Industrial Strategy, April 2017; assets.publishing.service.gov.uk. Lethal heat waves are defined as a wet-bulb temperature of 35° Celsius, at which level the body-core temperatures of healthy, well-hydrated human beings resting in the shade would rise to lethal levels after roughly five hours of exposure. Regulation S-KREF is the key regulation governing non-financial statement disclosures of registered (that is, public) companies. Policymakers should oppose efforts to redefine the purpose of business in the name of social justice; corporate social responsibility (CSR); stakeholder theory; environmental, social, and governance (ESG) criteria; socially responsible investing (SRI); sustainability; diversity; business ethics; or common-good capitalism. The FDIC’s interactions with payday lenders gained widespread notoriety in 2013 through Operation Chokepoint, a Department of Justice (DOJ) initiative that (ostensibly) was “intended to protect consumers from fraud perpetrated by fraudulent merchants, financial institutions, and financial intermediaries known as third-party payment processors (TPPP).”REF Amidst numerous public reports, several Members of Congress expressed concern over the FDIC working with the DOJ to pressure banks into denying accounts to customers in certain “high-risk” industries.REF Ultimately, the Inspector General absolved the FDIC of any major wrongdoing in Operation Chokepoint, and its report shows just how much discretion the FDIC has in such regulatory matters: Eventually, the FDIC changed its guidance and clarified its policy, explaining that its internal policy does not allow termination of customer deposit accounts based solely on reputational risks.REF Nonetheless, the FDIC clearly has the authority to create a new guidance policy that changes its current stance on reputational risk. Although it remains unclear exactly what the Administration and regulatory agencies will do, it is clear that the existing financial regulatory framework provides more than enough authority to implement a wide variety of new climate-related regulations. When regulators determine that an insured depository institution has (or is about to) engage in an unsafe or unsound practice, they can issue a “cease and desist” order.REF The law explicitly gives federal regulators “the authority to place limitations on the activities or functions of an insured depository institution or any institution-affiliated party.”REF. At some point, banks will no longer be able to justify lending in those areas. For further details, see the McKinsey Global Institute report “. Unleash their potential. Using Financial Regulation to Fight Climate Change: A Losing Battle, Infrastructure Bill’s “Unworkable” Cryptocurrency Surveillance Mandate Must Be Amended, Price Controls Do Not Work—Even in Credit Markets. The risk of a significant drop in grain yields—of 15 percent or more—and damage to capital stock from flooding will double by 2030. Among North American banks specifically, 48% said they consider climate change to be an emerging risk. Boards should regularly identify potential threats to strategic plans and business models. For starters: Why now? Kevin Stiroh, an executive vice president with the New York Fed, recently highlighted climate change as a major emerging risk to the U.S. economy during remarks at the GARP Global Risk Forum. 3. “Ultimately, for some of the other regulatory bodies to start to engage in the ways they’re doing in Europe, that’s probably going to take leadership from the top, whether it be the administration or Congress,” said Ivan Frishberg, director of impact policy at the $5 billion-asset Amalgamated Bank. Mounting losses from hurricanes, floods and wildfires have finally become too great for banking regulators to ignore, industry observers said. Risks may be manifested in such effects as coastal real-estate losses, land redundancy, and forced adaptation of sites or closure. Specifically, there are five capital-related steps financial regulators should take to mitigate climate-related financial risks: Adjust capital risk weights for bank exposures that face acute transition risks. Estimates are subject to uncertainty about aerosol levels and the urban heat-island effect. At the ECB, we are now launching a new climate change centre to bring together more efficiently the different expertise and strands of work on climate across the Bank. Climate Change and Global Poverty makes concrete recommendations to integrate international development and climate protection strategies. Banks should nominate a leader responsible for climate risk; chief risk officers (CROs) are often preferred candidates. The European Banking Authority (EBA) is establishing regulatory and supervisory standards for environmental, social, and governance (ESG) risks and has published a multiyear sustainable-finance action plan. These risks are typically classified as physical and transition risks. Federal regulators examine banks, depending on the size of the institution, at least once per 18-month period.REF At these on-site “full-scope” inspections, federal examiners give each bank a CAMELS rating under the Uniform Financial Institutions Rating System.REF The letters in the CAMELS acronym stand for capital adequacy, asset quality, management capability, earnings quality (and level), liquidity adequacy, and sensitivity to market risk.REF Both component and composite ratings are given on a scale of 1 to 5, with 1 indicating the strongest rating and 5 the weakest. Finally, banks have to quantify the impact by counterparty and in aggregate on a portfolio basis. Examiners have a great deal of discretion in calculating the CAMELS ratings, and each “component rating is based on a qualitative analysis of the factors comprising that component and its interrelationship with the other components.”REF, The CAMELS rating is much more than a mere supervisory tool. The banking industry is taking another step towards laying the groundwork to tackle the climate change threat with a new set of tools. of tools used in climate change policies around the world. Non-Fed-member state-chartered banks that are insured by the FDIC are regulated by the FDIC and state regulators. Please email us at: McKinsey Insights - Get our latest thinking on your iPhone, iPad, or Android device. For instance, federal agencies can regulate banks’ capital levels “by establishing minimum levels of capital” and “by using such other methods as the appropriate Federal banking agency deems appropriate.”REF, Failure to maintain adequate capital levels may “be deemed by the appropriate Federal banking agency, in its discretion, to constitute an unsafe and unsound practice,”REF ultimately terminating a bank’s ability to provide customers with FDIC deposit insurance.REF Precisely what constitutes adequate capital is also a matter of regulatory discretion, and the statutory code explicitly gives regulators the authority to determine adequate capital levels as they judge “to be necessary or appropriate in light of the particular circumstances of the banking institution.”REF. Some banks have already made significant strategic decisions, ramping up sustainable finance, offering discounts for green lending, and mobilizing new capital for environmental initiatives. Congress should statutorily define materiality in terms generally consonant with Supreme Court holdings on the issue, and should specifically exclude social and political objectives unrelated to investors’ financial, economic, or pecuniary objectives.REF. Indeed, energy efficiency has been improving for the past three decades because of private efforts, not government mandates.REF Finally, government should not be in the business of allocating credit to politically favored interests, and regulatory agencies should not have the enormous level of discretion that they currently do to impose regulations on financial institutions. A much better approach would be to allow companies to gauge their own risks without new government mandates, and to determine which of their risks are material to investors. Testing for the bank’s utilities subportfolio, for example, showed that electricity providers and multi-utilities fared worse than regulated networks. The recently established network of more than 60 central banks and regulators – the Network for Greening the Financial System ( NGFS ) – recognises the need for the banking industry to act and embed the management of climate change risks into its enterprise risk management ( ERM) frameworks and processes. The output from these models changes significantly with reasonable changes to the inputs. As climate risk seeps into almost every commercial context, two challenges stand out as drivers of engagement in the short and medium terms. Climate change has already altered industries, and banks have not escaped its reach. Within the Federal Reserve, Governor Brainard detailed how climate change impacts the Fed’s core objectives around monetary policy, financial stability, financial regulation and supervision, community and consumer affairs, and payments and describes efforts to … Thus, the OCC has the explicit authority to promulgate a rule that further restricts the types of loans that national banks are allowed to make. 2. ), As the guidance explains, in order to implement the FSOC’s activities-based approach for nonbank financial firms, the FSOC will “examine a diverse range of financial products, activities, and practices that could pose risks to U.S. financial stability.”REF The guidance also notes that the FSOC’s “annual reports highlight the types of activities the Council will evaluate,” and that these activities include “the extension of credit, maturity and liquidity transformation, market making and trading, and other key functions critical to support the functioning of financial markets.”REF. Stakeholders want robust action, and banks feel pressure to respond. Combined, these sections of Dodd–Frank give the FSOC and the Board of Governors a great deal of flexibility to develop prudential regulations for anything that they qualify as a risk factor, including climate change. Furthermore, federal financial regulators simply do not have the scientific expertise to police the accuracy of various climate models and of corporate prognostications on how climate change will affect operations a decade or more hence. These, in turn, may have direct and indirect negative impact on banks, including an increase in stranded assets, uncertain residual values, and the potential loss of reputation if banks, for example, are not seen to support their customers effectively. 2 People create and sustain change. A leading international bank aimed to increase its share of climate markets. The Australian Prudential Regulation Authority (APRA) will increase its scrutiny of how banks, insurers and superannuation trustees are managing the financial risks of climate change to their businesses. Found inside – Page 1Our intuition on how the world works could well be wrong. Many studies, and individual investment experiences, have demonstrated the links between environmental sustainability challenges and economic and financial risks – which leads to the inconvenient truth that climate change is a systemic threat to financial stability. Banks should also factor in adjacencies because lending to some clients in riskier geographies and industries—even to finance climate-related initiatives—is still riskier. The Bank published its own climate-related financial disclosure for the first time in June 2020 which sets out the Bank’s approach to managing the risks from climate change across its entire operations. The SEC is certainly incapable of policing the accuracy of issuers’ prognostications on the potential impact of climate change on their financial prospects a decade, or even many decades, from now. It will substantially increase issuer expenses and expose public companies to new liability exposure from private litigation and heighten regulatory risk. A closer look, however, shows that ordinary investors are demanding no such thing. The climate impact of quantitative easing. This series introduces early readers to the seven continents of our world. Students learn about the climate, landforms, plants, animals, and people of each continent. Labeled maps and fun facts further young readers' learning. To wit: Financial firms’ activities are highly regulated, more than those of most nonfinancial businesses. Found insideThe Impact of Climate Change on the UK Insurance Sector: A Climate Change Adaptation Report by the Prudential Regulation Authority. London: Bank of England, ... Joseba Eceiza is a partner in McKinsey’s Madrid office, Holger Harreis is a senior partner in the Düsseldorf office, Daniel Härtl is an associate partner in the Munich office, and Simona Viscardi is a partner in the Milan office. Banks must aim to embed climate-risk factors into decision making across their front- and back-office activities and for both financial and nonfinancial risks (including operational, legal, compliance, and reputational risks). The resulting risk score can be used to inform credit decisions and to create a portfolio overview. Standard & Poor’s saw the ratings impact of environmental and climate factors increase by 140 percent over two years amid a high volume of activity in the energy sector. “It is vital for monetary policymakers to understand the nature of climate disturbances to the economy, as well as their likely persistence and breadth, in order to respond effectively,” Fed Gov. The standards for Category III apply to banks with $250 billion or more in assets (that are not in the first two categories), and those for Category IV apply to banks with $100 billion or more (that are not in Categories I, II, or III).REF, Regarding nonbank financial firms, the FSOC recently issued guidance explaining its “activities based” approach to identifying, assessing, and addressing “potential risks and emerging threats on a system-wide basis.”REF According to that guidance, the FSOC will “pursue entity specific determinations under Section 113 of the Dodd–Frank Act only if a potential risk or threat cannot be adequately addressed through an activities-based approach.”REF (Section 113 recommendations are discussed below.) Banks often lack the technical skills required to manage climate risk. Found insideThis chapter examine how climate change can affect the financial sector. ... also anticipate a need for cooperation between banking regulators and banks to ... According to a recent risk management study by EY, 52% of banks surveyed ranked climate change as a key emerging risk in the next five years, compared with just 37% last year. Please try again later. Businesses would become less productive and less competitive. The Community Reinvestment Act (CRA). The FDIC has an enormous amount of leverage over financial institutions because it can terminate a bank’s status as an insured depository institution if it finds that the bank has engaged in or is “engaging in unsafe or unsound practices in conducting the business of such depository institution.”REF The FDIC, along with the other federal banking agencies, is responsible for determining what constitutes unsafe or unsound practices. Warming is unavoidable over the next decade public companies phase in greening the financial sector that warrants the heightened and..., 2021, executive management, business areas, group functions, and.. 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