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On October 24, 2023, the Regulatory Agencies jointly issued their principles for large banks on managing climate-related risk. Their goal was to “describe how climate-related financial risks can be addressed in the management of traditional risk areas, including credit, market, liquidity, operational, and legal risks… the draft principles were intended to support key climate-related financial risk management efforts by the largest financial institutions, those with over $100 billion in total consolidated assets.”

While the principles and specifics are currently intended solely for the largest banks, there is little doubt that the essence of the agencies’ plans will eventually trickle down to financial institutions of all sizes. They state in the opening page: “…all financial institutions, regardless of size, may have material exposures to climate-related financial risks” and “The agencies seek to promote consistency in their climate-related financial risk management guidance.”

Highlights of their principles, which should be of interest to all banks, include:

• “Similar to other risks faced by financial institutions, climate-related financial risks can affect financial institutions’ safety and soundness.”
• “The principles are designed to help financial institutions’ boards of directors (boards) and management make progress toward incorporating climate-related financial risks into risk management frameworks.”
• “The principles state that any financial institutions’ climate-related strategies should align with and support the institution’s broader strategy, risk appetite, and risk management framework.”
• “The agencies encourage financial institutions to take a risk-based approach in assessing the climate-related financial risks associated with their customer relationships …The principles neither prohibit nor discourage financial institutions from providing banking services to customers of any specific class or type, as permitted by law or regulation.”
• “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.”
• Specifically on Credit Risk: “Management should consider climate-related financial risks as part of the underwriting and ongoing monitoring of portfolios. Effective credit risk management practices could include monitoring climate-related credit risks through sectoral, geographic, and single name concentration analyses, including credit risk concentrations stemming from physical and transition risks.”

Specific principles outlined include:

• Governance: An effective risk management framework is essential to a financial institution’s safe and sound operation…The board should acquire sufficient information to understand the implications of climate-related financial risks across various scenarios and planning horizons.”
• Policies, Procedures, and Limits: Management should incorporate material climate related financial risks into policies, procedures, and limits to provide detailed guidance on the financial institution’s approach to these risks in line with the strategy and risk appetite set by the board.”
• Strategic Planning: The board should consider material climate-related financial risk exposures when setting and monitoring the financial institution’s overall business strategy, risk appetite.”
• Risk Management: Management should oversee the development and implementation of processes to identify, measure, monitor, and control exposures to climate related financial risks within the financial institution’s existing risk management framework.”
• “Tools and approaches for measuring and monitoring exposures to climate-related financial risks include… exposure analysis, heat maps, climate risk dashboards, and scenario analysis.”
• Data, Risk Measurement, and Reporting: Sound climate-related financial risk management depends on the availability of timely, accurate, consistent, complete, and relevant data. Effective risk data aggregation and reporting capabilities allow management to capture and report climate-related financial risk exposures.”
• Scenario Analysis: Climate-related scenario analysis is emerging as an important approach for identifying, measuring, and managing climate-related financial risks. Management should develop and implement climate-related scenario analysis frameworks.”

While the Agencies’ new climate-related risk management principles are currently targeted at institutions over $100 billion, many of their recommendations are in line with common risk management practices used today by banks of all sizes. Tracking exposure using concentration reports, trend analysis and stress testing scenarios are common credit risk best practices today.

A clear message is that the regulators believe that climate-related risk is now a significant issue, which justifies proactive management. Starting in 2024, baseline climate related risk management would be a prudent exercise.

For more information on Ardmore’s Climate-Related Credit Risk Management Service please click here.

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