New Regulatory Risk

by Timothy A. Schenk KBA Assistant General Counsel tschenk@kybanks.com

Climate Change: The New Regulatory Risk

A month ago, I led a compliance forum where I brought up the topic of climate change and what measures banks are taking to deal with climate change. One person immediately reacted, “What does climate change have to do with banks”? Surprising to some, the answer is a lot.

President Biden recently signed the Climate-Related Financial Risk Executive Order (Executive Order) that encourages banks and regulators to assess climate risks.

The executive order also tasked the Financial Stability Oversight Counsel to “assess, in a detailed and comprehensive manner, the climate-related financial risk” to the U.S. economy. That subsequent report “identified climate change as an emerging and increate threat to U.S. financial stability.”

The report also recommended member agencies:

• Assess climate-related financial risks to financial stability, including rough scenario analysis, and evaluate the need for new or revised regulations or supervisory guidance to account for climate-related financial risks;

• Enhance climate-related disclosures to give investors and market participants the information they need to make informed decisions, which will also help regulators and financial institutions assess and manage climate-related risks;

• Enhance actionable climate-related data to allow better risk measurement by regulators and in the private sector; and

• Build capacity and expertise to ensure that climate-related financial risks are identified and managed.

Regulators are moving quickly in response.

Comptroller of the Currency Michael Hsu said, “I have prioritized the need to incorporate climate change into risk management frameworks to address the safety and soundness of the federal banking system” and plans to publish “high level” supervisory expectations by year end. The Office of the Comptroller of the Currency also hired a Climate Change Risk Officer to help “prudently manage climate risk as a safety and soundness concern.” The Federal Reserve has taken similar steps. The Federal Reserve has created a “Supervision Climate Committee” to strengthen its “capacity to identify and assess financial risks from climate change and to develop an appropriate program to ensure the resilience” of its supervised institutions. Federal Reserve Board Governor Lael Brainard said the central bank will subject financial institutions to “scenario analysis” of their climate related risks.

Other federal regulators are expected to follow.

The Basel Committee on Banking Supervision quantifies the risks for the financial services industry as: physical risk consisting of direct loss of structures from storms etc.; and transition risk, which is the risk to the process of adjustment towards a low-carbon economy. So how can banks mitigate these risks? Banks across the country are turning to several areas to mitigate these risks.

Community Reinvestment Act

The Federal Reserve of San Francisco issued a white paper titled Climate Change and the Community Reinvestment Act. The white paper stated that “Low-to-moderate income (LMI) populations are highly vulnerable” to climate change “because they have fewer resources to adapt.” Banks are considering how climate change can impact their Community Reinvestment Act loans in LMI tracts and conducting cost-benefit analysis to determine whether climate related improvements should be included for the longevity of the project and to better serve the community.

Fair Lending

Fair lending is a leading priority for all of the federal banking agencies. The Executive Order affirms this priority by stating that climate change has a “disparate impact on minority communities” because they lack the savings available to pay for added expenses that makes banks generally inclined not to lend in these areas. As banks begin to modify their credit policies for climate change, they need to make sure there is no discrimination against an individual because of climate-related sensitivities, that they are not putting borrowers in loans they cannot afford in either the long or short term due to climate sensitivities, and that they uniformly underwrite mortgage loans to account for these added expenses.

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Flood Insurance

Flood-related fines have remained at the forefront of all enforcement actions across all banking agencies. Special Flood Hazard maps are changing quickly and banks must continually update their mapping to address flood risk. Utilizing flood vendors or services that maintain current maps and plotting will be critical to avoid costly fines.

Additionally, banks should consider flood insurance cost as part of its underwriting analysis to determine if a borrower can pay for flood insurance during the life of the loan.

Appraisals

Most bankers are familiar with traditional real estate appraisals. However, banks must ensure that appraisers adequately address climate change vulnerabilities into property valuation analysis to ensure they are properly collateralized. While climate change is a new area of compliance that is just developing, banks must begin to plan for climate-related regulatory changes. Compliance officers and other risk management employees should assess every area that climate change could impact their institution from a credit and operational perspective. Those with adopted plans will not only mitigate risk of loss in various forms, but will also be better prepared for examination by addressing these risks.

Smart decisions today. Lasting value tomorrow. ™

To learn more, visit crowe.com or contact Jennifer Monaghan at +1 502 420 4509 or jennifer.monaghan@crowe.com or Kristin McDonner at +1 502 420 4494 or kristin.mcdonner@crowe.com

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