Guidance for the largest US financial institutions is intended to promote climate risk management consistent with general safety and soundness practices.

By Sarah E. Fortt, Betty M. Huber, Arthur S. Long, Pia Naib, Karmpreet (Preeti) Grewal, Austin J. Pierce, and Deric Behar

On October 30, 2023, the three US federal bank regulatory agencies — the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) (collectively, the Agencies) — jointly finalized Principles for Climate-Related Financial Risk Management for Large Financial Institutions (the Principles).

The Principles are intended to provide large financial institutions (i.e., those with $100 billion or more in total assets) with a high-level framework for understanding and managing exposures to climate-related financial risks, including physical[1] and transition[2] risks. Such “financial institutions” include national banks and federal thrifts, state member banks, FDIC-insured state nonmember banks and savings associations, bank holding companies, savings and loan holding companies, intermediate holding companies, branches, agencies and the combined US operations of non-US banking organizations, and any systemically important non-banks that may become supervised by the FRB.

The Agencies asserted that the Principles are substantively similar to the draft principles (Draft Principles) published for comment in December 2021 (OCC), March 2022 (FDIC), and December 2022 (FRB). The Agencies published the Draft Principles, which were each subject to public comment, in response to the Biden Administration’s May 2021 Executive Order on Climate-Related Financial Risk (for more information regarding the December 2022 Draft Principles published by the FRB, see this Latham blog post).[3] The Agencies also maintained that the Principles are within their statutory mandates relating to safety and soundness, and consistent with the risk management framework described in existing rules and guidance.

The Principles do not impose requirements on financial institutions to promote a transition to a low-carbon economy. Indeed, the Agencies rejected some commenters’ assertions that the Principles were legislative rules subject to the notice and comment requirements of the Administrative Procedure Act, stating that “the [P]rinciples are being issued as guidance and, consistent with the [A]gencies’ rule on guidance, they will not have the force and effect of law. They do not establish any specific requirements applicable to financial institutions.”[4]How the Agencies will consider adherence, or the lack thereof, to the Principles in the examination process, however, is unknown at this time.

General Risk Management Principles

To support efforts by large financial institutions to focus on key aspects of climate–related financial risk management, the Agencies set forth the following Principles:

Governance

A financial institution’s board of directors (Board) should:

• understand climate-related financial risks that the institution may be exposed to;
• oversee the implementation by management (Management) of the institution’s business strategy, risk-taking activities, risk appetite, and risk management;
• hold Management accountable for adhering to the risk management framework and properly reporting to the Board;
• allocate appropriate resources to support climate-related financial risk management;
• challenge Management’s assessments and recommendations on climate-related risk management when appropriate;
• support the financial institution’s risk and internal audit functions; and
• assign accountability for climate-related financial risks within existing or new organizational structures.

A financial institution’s Management should:

• implement policies in accordance with the Board’s strategic direction and risk management framework;
• assure that the financial institution maintains sufficient expertise to execute the strategic plan and manage risks;
• oversee and implement processes to identify, measure, monitor, and control climate-related financial risks within the existing risk management framework;
• hold staff accountable for controlling risks within established lines of authority and responsibility;
• report accurately to the Board at regular intervals;
• support the financial institution’s risk and internal audit functions; and
• assign accountability for climate-related financial risks within existing organizational structures, and define the responsibilities of newly created units within existing governance structures.

Strategic Planning

A financial institution’s Board should:

• consider material climate-related financial risk exposures when setting and monitoring overall business strategy, risk appetite, and Management’s implementation of capital plans;
• consider the potential impact of material climate-related financial risk exposures on the institution’s financial condition, operations, and business objectives over various time horizons;
• encourage Management to consider climate-related financial risk impacts on the financial institution’s other operational and legal risks; and
• encourage Management to consider the impact that the institution’s strategies to mitigate climate-related financial risks could have on low-and-moderate-income (LMI) and other underserved communities and their access to financial products and services, consistent with the financial institution’s obligations under applicable consumer protection laws.

Policies, Procedures, and Limits

A financial institution’s Management should:

• incorporate material climate-related financial risks into policies, procedures, and limits; and
• modify policies, procedures, and limits (as needed) to reflect the distinctive characteristics of climate-related financial risks and changes in the financial institution’s operating environment or activities.

Risk Management

A financial institution’s Management should:

• oversee the development and implementation of processes to identify, measure, monitor, and control exposures to climate-related financial risks within the institution’s existing risk management framework;
• employ a comprehensive process to identify emerging and material risks related to the financial institution’s business activities, reflecting input from expert stakeholders across the organization;
• develop processes to measure and monitor material climate-related financial risks and to communicate and report the materiality of those risks to internal stakeholders; and
• incorporate material climate-related financial risks into the institution’s risk management system, including internal controls and internal audit.

Data, Risk Measurement, and Reporting

A financial institution’s Management should:

• incorporate climate-related financial risk information into the institution’s internal reporting, monitoring, and escalation processes; and
• monitor developments in data aggregation, risk measurement tools, modeling methodologies, and reporting practices, and incorporate them into the institution’s climate-related financial risk management when appropriate.

Scenario Analysis

The Principles state that scenario analyses are “exercises used to conduct a forward-looking assessment of the potential impact on a financial institution of changes in the economy, changes in the financial system, or the distribution of physical hazards resulting from climate-related financial risks.” Scenario analysis is different from traditional stress-testing exercises that “typically assess the potential impacts of transitory shocks to near-term economic and financial conditions.”

A financial institution’s Management should:

• develop and implement climate-related scenario analysis frameworks in a manner commensurate to the institution’s size, complexity, business activity, and risk profile;
• subject climate-related scenario analyses to oversight, validation, and quality control standards commensurate to the institution’s risk; and
• report results of climate-related scenario analyses to the Board and all relevant individuals within the institution.

Importantly, the Principles confirm that climate risks are an appropriate subject for financial institution scenario analysis or stress testing.

Traditional Risk Areas

According to the Principles, climate-related financial risks can exist within traditional micro-prudential risk areas, and should be addressed and mitigated wherever they may emerge. A financial institution’s Management should:

Credit Risk

• consider climate-related financial risks as part of the underwriting and ongoing monitoring of portfolios by, among other things, monitoring climate-related credit risks through sectoral, geographic, and single-name concentration analyses (including credit risk concentrations stemming from physical and transition risks);
• with respect to credit concentration (or correlations) risk analysis, assess potential changes in correlations across exposures or asset classes; and
• determine credit risk tolerances and lending limits related to material climate-related financial risks.

Liquidity Risk

• assess whether climate-related financial risks could affect the financial institution’s liquidity position and, if so, incorporate those risks into their liquidity risk management practices and liquidity buffers.

Market Risk

• monitor interest rate risk and other model inputs for greater volatility or lower predictability due to climate-related financial risks; and
• monitor how climate-related financial risks affect the institution’s exposure to risk related to changing prices.

Operational Risk

• consider how climate-related financial risk exposures may adversely impact an institution’s operations, control environment, and operational resilience; and
• consider climate-related impacts on business continuity and the evolving legal and regulatory landscape.

Legal and Compliance Risk

• consider how climate-related financial risks and risk mitigation measures affect the legal and regulatory landscape in which the institution operates; and
• ensure that fair lending monitoring programs review whether and how the institution’s risk mitigation measures potentially discriminate against consumers on a prohibited basis, such as race, color, or national origin.

Other Nonfinancial Risk

• monitor (with the Board) how the execution of strategic decisions and the operating environment affect the institution’s financial condition and operational resilience; and
• consider the extent to which the institution’s activities may increase the risk of negative financial impact, and implement adequate measures to account for these risks if material.

A Note on Materiality

A frequent comment on the Draft Principles was the request for further clarification of how financial institutions should determine whether climate-related financial risks are material. The Agencies did not provide well-defined recommendations for assessing climate risk materiality in the Principles, but rather suggested that materiality of climate-related financial risks be determined in a manner similar to other risks: “The Principles provide that financial institutions management should employ comprehensive processes for identifying climate-related financial risks consistent with methods used to identify other types of emerging and material risks.”

Regulators Weigh In

• FRB Chair, Jerome H. Powell, published a statement in support of the Principles, clarifying that they are within the FRB’s remit of bank supervision, and that the financial risks of climate change must be prudently and appropriately managed by financial institutions along with other material risks. In promulgating the Principles, the FRB is not (according to Chairman Powell’s statement), taking on the federal or state legislatures’ role of policymaker.
• FRB Vice Chair for Supervision, Michael S. Barr, published a statement in support of the Principles, echoing Chairman Powell’s points. He also highlighted the risk-based approach that the Agencies set forth, and the importance of preventing unintended negative consequences in the availability of “banking services to customers of any specific class or type.”
• FRB Governor, Michelle W. Bowman, published a statement of dissent, stating that the Principles “will create confusion about supervisory expectations and will result in increased compliance cost and burden without a commensurate improvement to the safety and soundness of financial institutions or to the financial stability of the United States.” She criticized the Principles for “climate policymaking,” for the lack of specifics and ambiguity in various respects (such as time horizons), and for the potential unintended consequences they may cause (such as, according to her statement, institutional resource allocation for risk management away from core risks, and the steering of financial services in certain directions, likely to the detriment of LMI and other underserved communities).
• FRB Governor, Christopher J. Waller, published a statement of dissent, stating that he disagrees that climate risks are a threat to the safety and soundness of the US financial system, or that they are “sufficiently unique or material to merit special treatment relative to other risks.”
• OCC Acting Comptroller, Michael J. Hsu, published a statement in support of the Principles, defending their issuance pursuant to the OCC’s role in overseeing the safety and soundness of the US banking system. He asserted that “it is better to address risks as they emerge, rather than after they’ve caused damage. This philosophy underpins prudent risk management, safety and soundness, and these Principles.”
• FDIC Chairman, Martin J. Gruenberg, published a statement in support of the Principles, echoing the sentiments of FRB Chairman Powell and OCC Acting Comptroller Hsu. In his statement, he emphasized that the FDIC is not acting as a climate policymaker, but is focused on “the financial risks that climate change may pose to the banking system and individual institutions, and the extent to which those risks impact the FDIC’s core mission and responsibilities.”

Conclusion

The Principles were proposed separately but finalized jointly, indicating that the federal banking regulators have, for now, taken a unified stance on the issue of climate-related financial risks. What they expect from the largest financial institutions is clear, at least in the broad strokes: Boards and Management should actively identify, measure, monitor, and control climate-related financial risks that have the potential to adversely affect their own safety and soundness, and that of the larger financial system. Financial institutions are expected to take a tailored approach in assessing and addressing these risks, and should be careful of the effects that climate risk management may have on LMI and other underserved consumers and communities.

Latham & Watkins will continue to monitor developments regarding this topic and related areas.

Endnotes

---

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

[2] Transition risks are defined as the stresses to institutions or sectors arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes that would be part of a transition to a lower-carbon economy.

[3] One notable difference is that the Principles as finalized remove a requirement in the FRB’s Proposal that a Board should consider compensation policies in light of the incorporation of climate-related financial risks into the institution’s overall business strategy and risk management framework.

[4] 88 Fed. Reg. 74183, 74186 n.7 (October 30, 2023).