On March 29, 2022, the Federal Deposit Insurance Corporation (FDIC) joined multiple other regulators in releasing guidance outlining how financial institutions should measure and plan for potential climate-related financial risk. The FDIC specifically outlined how financial institutions can measure the operational risks posed by climate change and the transition to new energy technologies. This guidance largely mirrors the previous request for information from the Office of the Comptroller of the Currency (OCC) in December 2021, in which the OCC requested feedback on its draft principles addressing climate-related financial risk. Both announcements are designed to support the efforts of financial institutions with more than $100 billion in total consolidated assets to better identify and manage climate-related financial risks. The FDIC is requesting feedback on its guidance by June 3, 2022.
The FDIC’s proposed guidance is in response to its identification of the effects of climate change and the transition to a low-carbon economy, and the impact of both on the safety and soundness of financial institutions and overall stability of the financial system. The FDIC, similar to the OCC announcement, emphasized to financial institutions and their executives how they should incorporate governance, strategic planning, risk management, and scenario analysis into their risk frameworks. These similarities are detailed in Section 2, Draft Principles, and Section 3, Management of Risk Areas, of our January 2022 client alert. The FDIC also provided additional detail regarding potential economic and financial risks stemming from the physical and transition risks of climate change1,2. According to the proposed guidance, examples of these risks include the potential for:
Reduced profitability and thus reduced ability to repay debt.
Lower asset values for assets that are less productive in a low-carbon environment.
Increased litigation, liability, legal, and regulatory compliance risks associated with climate-sensitive investments and businesses.
Lower financial asset valuations due to market participants revaluing the future impacts of both physical and transition risks on financial performance.
The FDIC observes that if financial institutions are unable to accurately identify, measure, and monitor the physical and transition risks associated with climate change, the resulting adverse effects to the financial system would have widespread negative consequences, and would disproportionately impact the financially vulnerable or low- to moderate-income (LMI) households and communities. The FDIC noted they would be providing additional guidance that will “distinguish roles and responsibilities of boards of directors (boards) and management, incorporate the feedback received on the draft principles, and consider lessons learned and best practices from the industry and other jurisdictions.”
Differences to OCC Announcement
As noted above, the FDIC’s proposed guidance is substantially similar to that of the OCC’s request for feedback on its draft principles. Notable differences, stemming in part from the fact that the FDIC oversees the entire financial system, include:
Overall Stability of the Financial System – The FDIC placed a greater emphasis on how climate-related financial risks may impact the entire financial system. The FDIC believes that, if financial institutions do not respond to the threat of climate change, these risks will become systemic and compound across the entire financial system, raising concerns regarding financial stability.
Example Impacts from Physical and Transition Risks – As highlighted above, the FDIC outlined a handful of economic and financial impacts stemming from the emerging physical and transition risks climate change poses.
Fair Lending – The FDIC solicited opinions on whether it should modify guidance related to the “Community Reinvestment Act to address the impact climate-related financial risks may have on LMI and other disadvantaged communities?”
Risk Management Practices – The FDIC sought comments on whether it should impose regulations or guidance to prescribe particular risk management practices for financial institutions.
Benefits of Scenario Analysis – The FDIC more clearly outlined the benefits of performing scenario analysis, specifically how scenario analysis can help identify, measure, and manage climate-related risks, as well as risk assessment processes and frameworks.
While the FDIC is focusing on financial institutions with more than $100 billion in assets, all financial institutions should consider aligning their organizations to the proposed principles and make the changes necessary to ensure they are well-positioned to manage climate-related risk. Entities should consider proactively assessing their exposure based on the draft principles and review the areas of risk highlighted by the FDIC as they relate to the entities’ existing risk management framework. This includes identifying and assessing any climate-related enterprise risks not included in their current frameworks that could inhibit compliance with the proposed principles or negatively impact their financial status.
Call to Action
Guidehouse can help financial institutions and management teams assess their risk management frameworks in light of the draft principles proposed by the FDIC. Guidehouse has a deep bench of financial services and climate and energy professionals with decades of public and private sector experience and a strong understanding of the climate environment in which financial institutions operate. Among other capabilities, Guidehouse can quickly review and assess your risk management framework to determine whether it is sound, identify gaps or weaknesses, and provide recommendations to ensure it aligns with the FDIC’s draft principles. Guidehouse is well-equipped to make an individualized assessment of your unique circumstances and offer innovative advice and solutions for responding to potentially heightened regulatory requirements.
Special thanks to Henry Darmstadter for contributing to this article.
1Physical Risks: Damage to property, infrastructure, and business disruptions, all of which have real effects to the value of property securing financial institutions’ exposures and borrowers’ ability to perform on their obligations. 2Transition Risks: Companies or sectors may become less competitive in a transition to a low-carbon economy due to policies designed to reduce carbon emissions or carbon equivalents (e.g., carbon pricing), technological advances, and changes in investor and public preferences.