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“The Financial Risks of Climate Change”

Chairman (Acting) Martin J. Gruenberg
 Speech, American Bankers Association Annual Convention  
October 3, 2022

Thank you very much for giving me the opportunity to speak with you this morning. I particularly want to express my appreciation to Rob Nichols for the invitation.

I would like to share with you some thoughts this morning on a topic that has received considerable attention and is the source of some concern within the banking industry, particularly with smaller institutions – the financial risks associated with climate change, and the impact they may have on the financial system and financial regulation.

Before I begin, there are two points that I want to make clear:

First, the FDIC’s core mission is to maintain stability and public confidence in the U.S. financial system. We carry out this mission through responsibilities for deposit insurance, banking supervision, and the orderly resolution of failed banks, including systemically important financial institutions. Therefore, our role with respect to climate change is centered on the financial risks that climate change may pose to the banking system, and the extent to which those risks impact the FDIC’s core mission and responsibilities.

Second, the FDIC is not responsible for climate policy. As such, we will not be involved in determining which firms or sectors financial institutions should do business with. These types of credit allocation decisions are responsibilities of financial institutions. We want financial institutions to fully consider climate-related financial risks—as they do all other risks—and continue to take a risk-based approach in assessing individual credit and investment decisions.

There are three parts to this speech. First, a general discussion of the financial risks of climate change. Second, a section defining with some specificity climate-related financial risk. And third, a discussion of what the FDIC has been doing in regard to the financial risks of climate change.

Climate Change is a Risk to the Financial System 

The financial system has always had severe weather events to contend with and, thus far, the banking industry has handled these events well. Agricultural banks know well the effects that drought conditions can have on farming communities; banks in the west understand the impacts of wildfires; and coastal banks have long responded to the annual threat of tropical storms and hurricanes.

However, changing climate conditions are bringing with them challenging trends and events, including rising sea levels, increases in the frequency and severity of extreme weather events, and other natural disasters.1

These trends challenge the future resiliency of the financial system and, in some circumstances, may pose safety and soundness risks to individual banks. It is the goal of our work on climate-related financial risk to ensure that the financial system continues to remain resilient despite these rising risks.

Historically, we have viewed financial crises as stemming from developments in the economy or the financial system. In the United States, this was true of the banking crisis of the 1930s, the thrift crisis of the 1980s, and the global financial crisis of 2008. We have not generally considered sources exogenous to the economic and financial systems as potential causes of financial crises.

However, we have learned from the pandemic that exogenous shocks can have a profound impact on the economy and financial system. In 2020, the Financial Stability Oversight Council (FSOC), made up of the U.S. Treasury and the federal financial regulatory agencies, described COVID-19 as “the biggest external shock to hit the post-war U.S. economy.”2 Climate change and the potential responses to limit its effects could also result in exogenous shocks to the banking system.

There is broad consensus among financial regulatory bodies, both domestically and abroad, that the effects of climate change and the transition to reduced reliance on carbon-emitting sources of energy present unique and significant economic and financial risks, and, therefore, an emerging risk to the financial system and the safety and soundness of financial institutions. 

The Financial Stability Board (FSB) of the G-20 countries has warned that climate-related risks may also have a profound impact on the stability of the global financial system. In 2020, the FSB stated that “climate-related risks may also affect how the global financial system responds to shocks” and could “amplify credit, liquidity and counterparty risks and challenge financial risk management in ways that are hard to predict.”3

Last October, the FSOC issued a public report that identified climate change as an emerging threat to the U.S. financial system, stating that “climate change will likely be a source of shocks to the financial system in the years ahead.”4

Defining Climate-Related Financial Risk 

Financial institutions are likely to be affected by both the physical risks and transition risks associated with climate change. Together these are generally referred to as climate-related financial risks.

Physical Risks 

Physical risks generally refer to the harm to people and property arising from acute, climate-related events, such as hurricanes, wildfires, floods, and heatwaves, as well as chronic shifts in the climate, including higher average temperatures, changes in precipitation patterns, sea level rise, and ocean acidification.

Transition risks generally refer to stresses to certain financial institutions or sectors arising from the shifts in public investment, consumer and business preference, or technologies associated with a transition toward reduced carbon reliance.

While physical and transition risks are separate and distinct risks faced by the financial system, both may materially increase the risks posed to a financial institution’s financial condition.

For example, acute physical risks, such as flooding, hurricanes, wildfires, and droughts, may result in sudden, significant, and recurring damage to properties securing exposures held by financial institutions or may otherwise disrupt the operations of their business clients. Some of these properties may be properties that financial institutions currently consider to be outside of flood plains or in areas less prone to this type of damage.

Longer-term physical risks, such as rising average temperatures and sea levels may increase the risk to property values and drive migration patterns, which may result in detrimental impacts to household wealth, corporate profitably, local economies and municipalities.5 Further, growing physical risk impacts, including their economic costs, may also have an increasing influence on behavior as individuals and businesses prioritize geographic areas less exposed to physical risks.6

While current insurance policies may cover some or all of the loss associated with many severe weather events, policies may over time become more expensive or unavailable to cover losses for a particular geographic area or business activity, particularly if faced with increasing severity and frequency of severe weather events.7

Additionally, while the U.S. government may provide assistance with the costs associated with many severe weather events, financial institutions should not be wholly dependent on this assistance, whether directly or indirectly.

Transition Risks 

In addition to physical risks, transition risks may also pose material risks to financial institutions’ financial condition in several ways.

Public or private spending designed to reduce carbon emissions or mitigate the risks of climate change, technological advances, and changes in investor and public preferences may all contribute to and accelerate a transition to a lower-carbon economy.8

Advancements in technology have the potential to accelerate the development of lower-carbon energy sources, for example, if investor and public preferences and behavior results in a shift towards more energy efficient assets and companies earlier than otherwise expected.

In each case, certain companies or sectors may face increased competition or lowered revenue, resulting in reduced profitably and ability to repay obligations, as well as reductions in the value for certain assets that are less productive in a lower-carbon environment.

Increasing marketplace demand for the evaluation and disclosure of climate-related financial risks may influence investment decisions made by broader market participants, or result in a shift in market, consumer, or investor preferences that may trigger material decreases in the value of certain assets or groups of assets on their balance sheet and contribute to broader volatility of portfolio performance.

Further, climate-related financial risks are increasingly reflected within the assessment of credit quality of corporate, sovereign, and municipal exposures, as credit rating agencies and investor due diligence processes begin to reflect these risks in investment decisions.

It is clear that climate-related financial risk poses a significant near and long-term risk to the U.S. financial system and, if improperly assessed and managed, may pose a risk to safe and sound banking and financial stability.

Climate Related Financial Risk and the FDIC 

Understanding and addressing the financial risks that climate change poses to financial institutions and the financial system is a top priority of the FDIC. However, it is important to note that we are in the early stages of understanding and addressing climate-related financial risk. There is significant work ahead of us.

We need to foster a better understanding of how the physical and transitional risks of climate change manifest as risks to the financial system, individual financial institutions, and the communities they serve. We also need more and better data to more fully understand the exposures to these risks and for the development of methodologies to analyze them. But, importantly, we need more and better dialogue with our counterparts in the U.S. and international financial regulatory bodies, and especially with stakeholders throughout the banking industry.

A Cross-Disciplinary, Interagency Approach with International Engagement 

The FDIC is working to develop a fuller, more formal and dedicated, agency-wide understanding of climate-related financial risk.

This year, we established an internal, cross-disciplinary working group to assess the safety and soundness and financial stability considerations associated with climate-related financial risk and to develop an agency-wide understanding of climate-related financial risk in all its forms.

The FDIC is also coordinating with our interagency peers and is participating on the FSOC’s Climate-related Financial Risk Committee.

Further, as climate change is an international problem, the FDIC, along with the Federal Reserve and the Office of the Comptroller of the Currency, have joined the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) to foster collaboration and share best practices in addressing climate-related financial risks on a global basis. This complements our existing work with the Basel Committee’s Task Force on Climate-related Financial Risks and other appropriate international organizations.

Proposed Statement of Principles for Climate-Related Financial Risk Management 

Even though we may be in the early stages of addressing climate-related financial risk, regulators need to work with the industry now to support financial institutions as they develop plans to identify, monitor, and manage the risks posed by climate change. We must do this in a manner that is flexible enough to allow for change as knowledge is gained, data are developed, and new methodologies and tools are explored.

Consistent with this, the FDIC issued a request for comment in March on draft principles that would provide a high-level framework for the safe and sound management of exposures to climate-related financial risks. This request for comment is substantively similar to the principles that were issued by the Office of the Comptroller of the Currency in December of last year. The FDIC’s comment period closed in June and comments are currently under review and consideration.

The principles take a risk-based approach, and are consistent with the risk management framework described in existing FDIC rules and guidance.9 Notably, while the FDIC views climate-related financial risks as potentially impacting all financial institutions, regardless of size, the draft principles are intended for large financial institutions, those with over $100 billion in total consolidated assets.

The principles are intended to support efforts by financial institutions to focus on the key aspects of climate-related financial risk management. The request for comment includes general, high-level principles for incorporating climate-related financial risk into an institution’s governance and risk management practices. The principles also address how climate-related financial risks could impact a financial institution’s assessment of traditional risk areas, such as credit and other financial and nonfinancial risks, with respect to climate-related financial risk.10

Additionally, the draft principles are intended to support the use of scenario analysis as an emerging and important approach for identifying, measuring, and managing climate-related financial risk. Climate-related scenario analysis generally refers to the methods used to conduct forward-looking assessments of the potential impact of changes in the economy, financial system, or distribution of physical hazards resulting from climate-related risks.11 Climate-related scenario analyses should be designed and used by institutions for building knowledge and capabilities associated with climate-related financial risk management, as well as for better understanding gaps in methodologies and data. Further, scenario analysis is intended for the large institutions, particularly for those that cross multiple communities, and is not intended for smaller institutions.

To be clear, I view scenario analysis as an exploratory risk management tool designed to better understand the range of climate-related financial risks that may impact a large, individual institution and the financial system as a whole. Scenario analysis is not a stress testing exercise and will not have regulatory capital implications.

The proposed Statement of Principles represents an initial step toward the promotion of a consistent understanding of the effective management of climate-related financial risks. The FDIC intends to continue to work on an interagency basis with the OCC and Federal Reserve and, as appropriate, will provide further guidance for climate-related financial risk management, especially for large banks.

Banking Industry Engagement 

I want to reiterate that our mandate is focused on effective risk management practices, which should be appropriate to the size of the institution and the nature, scope, and risk of its activities. Credit and capital allocation decisions are those of the institution. When considering climate-related financial risk as part of these business decisions, whether directly or indirectly, institutions should do so in a risk-based manner.

I described earlier in my remarks some ways in which climate-related financial risk may impact financial institutions. Climate-related financial risk presents unique, serious, and unknown risks to all banks of all sizes, regardless of complexity or business model. Some banks may have more concentrated exposures, regardless of asset size, and, for such institutions, the impact of climate-related financial risk may be greater.

We recognize and acknowledge that current and past strategies used by smaller and mid-size institutions for managing climate-related financial risk have been successful so far, and undertaken with limited resources. Some strategies include consulting weather, agricultural, and other non-financial data, managing exposures within flood plains, and assessing the impact of extreme weather events. Further, community banks, by their nature, have a wealth of first-hand perspectives and experiences from providing essential banking and financial services to the local communities they serve. This also has included in times of great need, such as after an extreme weather event or natural disaster.

But we also should recognize that climate change will increase the prevalence of climate-related financial risk. Overreliance on insurance and government support presents additional risks, as these may not be able to compensate for losses to the same extent as they have in the past, or could become more expensive. This may stress the ability for smaller institutions to mitigate climate-related financial risk.

We need to explore new ways in managing these risks, particularly in light of the unique and important role that smaller and mid-size banks play in their communities. The risk management landscape is shifting due to the characteristics of climate change, which could potentially impact the effectiveness of past mitigation strategies.

However, heightened exposures and increased uncertainty must not result in unreasonable expectations on the part of regulators. We understand that smaller and mid-size banks have limited resources relative to larger banks. Similar to other risk areas, supervisory expectations are tailored based on size, complexity and business operations – we do not expect a community bank to manage credit risk the same way as the largest institution and we would not expect the same for climate-related financial risk. We have the benefit of leveraging experiences of community banks for developing tailored, flexible, and cost-effective risk management approaches.

We recognize the desire from many institutions for further guidance and clear supervisory expectations in the future regarding the management of climate-related financial risk. The FDIC would appropriately tailor any future supervisory expectations to reflect differences in financial institutions’ circumstances, such as complexity of operations and business models.

In the near term, banks, including community and mid-size banks, should seek to better understand and consider their own unique climate-related financial risk and how it may impact them.

As an initial step, boards of directors and senior management may wish to seek a better understanding about how climate change and climate-related financial risk are impacting the institution’s business, customers, and communities, and how this risk may evolve over time.12

Banks may wish to consider developing appropriate sound governance frameworks and processes that have the capability for incorporating the assessment and management of climate-related financial risk as appropriate to their size, complexity, and risk profile. The FDIC views strong corporate governance as the foundation for safe-and-sound operations. Effective governance frameworks help maintain profitability, competitiveness, and resiliency through changing economic and market conditions. Building this internal infrastructure and leveraging these processes early will assist institutions with prudently managing unforeseen climate-related shocks, as well as any potential gradual cumulative impacts of climate-related financial risk. Simply put, it’s just good governance to be prepared. And we can prepare now.

Conclusion 

In conclusion, the FDIC recognizes risk management practices in this area are evolving. We will continue to engage with other regulatory bodies and the industry on how we can all best address climate-related financial risk. Again, we need more dialogue.

I want to stress that we are in the beginning and that the FDIC will continue to expand its efforts to address climate-related financial risks through a thoughtful and measured approach. We will emphasize risk-based assessments and collaboration with other supervisors and industry, and, our actions will complement the actions taken domestically and internationally.

Importantly, the FDIC will continue to encourage financial institutions to consider climate-related financial risks in a manner that allows banks to prudently meet the financial services needs of their communities.

However, as I have previously stated, we have a compelling obligation to engage with climate change as a financial risk to the safety and soundness of banks and the stability of the financial system.

We cannot escape climate change, its risk, or its uncertainties, but we, as leaders, can prepare for it. And we have a responsibility and an obligation to our organizations and our communities to do so.

Thank you.

Last Updated: October 3, 2022