Regulatory developments regarding climate change in the last year have proven successfully managing related risks requires attention from multiple levels of a business. The board of directors is no exception.
It is with this in mind that Michael Hsu, acting head of the Office of the Comptroller of the Currency (OCC), shared remarks at the agency’s headquarters Monday exploring the role of bank boards to promote improvements in climate risk management practices at their banks.
“Bank boards have a critical role to play in turning words into action and, in doing so, can be a strong force for good,” he said. “In board meetings, the questions that directors ask senior managers can shift bank priorities, reveal hidden strengths, expose fatal weaknesses, and spur needed changes. The most influential board members—the ones who are highly effective in moving the needle and driving change—tend to ask the most probing questions and expect the most of their management team.”
Hsu noted the OCC will issue high-level framework guidance for large banks on climate risk management by the end of the year, followed by detailed guidance for each risk area during 2022. In the meantime, he offered the following five questions bank boards should be asking to gauge where their financial institution’s efforts stand.
Question 1: What is our overall exposure to climate change?
This cannot be simply summed up, Hsu noted. Bank senior managers need to “develop a framework, a risk taxonomy, metrics, data, scenarios, and a strong understanding of the first- and second-order impacts that physical and transition risks may have on the bank’s portfolio,” he said.
Multiple data points are required to grasp exposure to climate change risk. Hsu recommended banks should, at minimum, be conducting “what if?” scenario analyses to determine data gaps and begin building good core practices.
Question 2: Which counterparties, sectors, or locales warrant our heightened attention and focus?
“Identifying those borrowers and sectors most likely to see deterioration in their ability to repay or in their collateral values under potential physical and transition risk scenarios is a critical first step to prudently managing climate risk,” Hsu said.
Physical risks, as defined by the Financial Stability Oversight Council, include wildfires, rising sea levels, and stronger and more powerful storms, while transitional risks relate to changes in policy and public sentiment to entities that produce carbon emissions. Certain communities may be more vulnerable to one over the other depending on economic strategy.
Question 3: How exposed are we to a carbon tax?
Hsu noted the chances of the United States adopting a carbon tax soon are “low.” That said, he acknowledged exposure analysis regarding a carbon tax might be a good place for banks to start assessing their risks.
“It is a way to flesh out, at the aggregate level, the most significant exposures, the biggest concentrations of risk, and the most highly correlated positions,” he said. “More important than the estimate itself, the exercise of coming up with a number will require processes, data, and calculations that will strengthen transition risk measurement practices more broadly. Those capabilities may, in turn, enable more refined assessments of more complex and more likely transition risks in the future.”
Question 4: How vulnerable are our data centers and other critical services to extreme weather?
Modern banks must understand physical risks facing their third parties as much as their own. “To the extent that critical service providers are vulnerable to climate change, banks’ abilities to continue critical operations may be affected,” Hsu said.
Extreme weather volatility might require banks to do additional analysis and adjust preparedness accordingly.
Question 5: What can we do to position ourselves to seize opportunities from climate change?
A low-carbon economy will look and function different than what we are used to today, Hsu noted. With that change will come business opportunities that will allow U.S. banks to keep pace with their international counterparts undertaking similar initiatives.
Bank boards asking any of these five questions now shouldn’t be surprised to hear management reply, “‘We don’t know,’” Hsu said. The goal is for boards to “put into motion the concrete steps that banks need to take to prudently manage climate risk,” he said.