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by Peter Cherpack

On August 13th, the FDIC issued a quarterly report on the impact on specific metro areas of the United States being highly concentrated in declining (transitioning) industries. They studied 50 years of economic data from these metro areas and 35 years of community bank data to form their conclusions.

What is “Transition Risk” and how is it part of climate-related credit risk?

Representatives from the US financial regulatory agencies including the Fed, OCC, FDIC and SEC have all openly discussed their concerns about the impact of climate change as emerging areas of significant credit risk. While guidance so far has only been issued for the largest US banks, in Europe and Asia, strict financial regulation based on climate-related credit risk for all banks is already in place.

Generally, the financial industry is concerned about two types of climate-related credit risk – acute physical risk resulting from climate related events (earthquakes, floods, wildfires, etc.) and transition risk – the risk of lending to industries with higher carbon footprints that are likely to decline based on pending carbon limits and customer preference for a greener future.

Physical climate risk is easier for most bankers to understand, as flood and other environmental risks have been taken into account in lending for quite some time. In addition, you only have to look out the window, or watch the news for examples of the impact of growing instances of flood, fire and other climate events.

Transition risk is more long-term, and harder to readily understand. In many cases, transition of industries can take decades, longer than most smaller bank strategic plans. Conversely, some western states are already passing state laws that will hasten the decline of high carbon industries such as mining, chemical manufacturing and transportation.

Why did the FDIC conduct the study?

US regulatory agencies have struggled with the concept of managing transition credit risk, largely due to the politically charged atmosphere that surrounds higher carbon industries which are often tied to specific US states and metro areas. The Federal government will not “condemn” specific industries or instruct banks who to lend or not lend to. However, the risk of banks being concentrated in assets that are at high risk of decline due to the transition to lower carbon economy is real, and the regulators want bankers to be aware of it.

By surveying the history of the impact on community banks that are concentrated in industries that have largely transitioned away, the FDIC has created a “proxy” model for the potential impact on community banks of climate-related transition risk. While certainly not a reflection of all of the aspects of climate- related credit risk, the history of declining industries is worth studying.

What did they analyze for the study?

From 1970 through 2019, due to factors like automation, increased globalization and aging population, a number of industries significantly declined, including manufacturing, metals and mining and textiles. The FDIC identified the US metro areas that had the highest concentration in these industries (“High Transition Metro Areas”) and then looked at those area’s relative economic performance versus the rest of the country’s metro areas. They then looked at community banks located in the High Transition Metros and studied their performance over the past 35 years. This information could illustrate a pattern that may repeat with high carbon industries that will need to transition due to climate-related credit issues.

What did the FDIC conclude from the study?

As could be expected, the results were somewhat mixed, and require some interpretation – but overall “high transition metro areas” performed economically worse than their lower transition peers, and “high transition community banks” performed worse in many areas than their lower transition peers. Specifically, the high transition areas had lower employment growth, slower income and per capita income growth, and less overall population growth over the period studied.

High transition community banks, on average, opened fewer branches, saw weaker deposit and loan growth, and had lower asset quality. Generally, the vast majority of these banks were somewhat adversely impacted by being in a high transition metro. That said, the differences weren’t huge, and some high transition metro community banks actually did better in times of economic crisis – likely due to needing to add less provisions and having already low net income margins.

What can we learn from this?

While not extremely conclusive, Ardmore believes that there are some meaningful takeaways from the study:

• The fact that the FDIC conducted this study to show bankers correlations of concentrations in transitioning industries with lower bank performance illustrates their concern about this area of emerging credit risk
• Bank management and their boards should already be aware of the dangers of concentration risk, and transition climate-related credit risk is a real, growing concern
• Banks should consider the impact of exposure to large amounts of high carbon industries in their long- term business plans

As the famous writer and philosopher George Santayana once wrote, “Those who cannot remember the past are condemned to repeat it.” The FDIC seems to want to remind bankers of the not too distant past, and how concentrations in transitioning areas and industries can be a serious credit risk.

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