Last year, President Joe Biden’s Executive Order on Climate-Related Financial Risk and the resulting report from the Financial Stability Oversight Council identified climate change as an emerging and increasing threat to U.S. financial stability.
A number of financial regulatory and agency heads have also spoken about climate risk and bank vulnerability.
Now the question is: What should banks be doing about it now? Here are three steps you can take to get started:
1. Conduct a Risk Assessment
Assessing a financial institution’s exposure to climate risk poses an interesting set of challenges. There is the short-term assessment for both internal operations and business exposures: what is happening today, next month or next year. Then there are long-term projections, for which modeling is still being developed.
So where to begin?
Analyzing the potential impacts of physical risk and transition risk begins with the basic question, “What if?” What if extreme weather events continue, how does that impact or alter your operational and investment risks? What if carbon neutral climate regulations take hold and emissions rapidly fall? Widen your scope from credit risk to include market, liquidity and reputational risk, which is taking on new meaning. Bank executives may make reasonable decisions to stabilize their balance sheet, but those decisions could backfire when banks are seen as not supporting their customers in their transition.
Regional and smaller financial institutions will need more granular data to assess the risk in their portfolios, and they may need to assemble local experts who are more familiar with climate change’s impact on local companies.
2. Level Up the Board of Directors
Climate change has long been treated as part of corporate social responsibility rather than a financial risk, but creating a climate risk plan without executive support or effective oversight is a fool’s errand. It’s time to bring it into the boardroom.
Banks should conduct a board-effectiveness review to identify any knowledge gaps that need to be filled. How those gaps are filled depends on each organization, but climate change expertise is needed at some level — whether that be a board member, a member of the C-suite or an external advisor.
The next step is incorporating climate change into the board’s agenda. This may already be in place at larger institutions or ones located in traditionally vulnerable areas. However, recent events have made it clear that climate risk touches everything the financial sector does. Integrating climate risk into board discussions may look different for each financial institution, but it needs to start happening soon.
3. Develop a Climate-Aware Strategy
Once banks approach climate risk as a financial risk instead of simply social responsibility, it’s time to position themselves for the future. Financial institutions are in a unique position when formulating a climate risk management strategy. Not only are they managing their own exposure — they hold a leadership role in the response to carbon neutral policies and regulation.
It can be challenging, but necessary, to develop a data strategy with a holistic view across an organization and portfolio to reveal where the biggest risks and opportunities lie.
Keeping capital flowing toward clients in emission industries or vulnerable areas may seem like a high risk. But disinvestment may be more detrimental for those companies truly engaged in decarbonization activities or transition practices, such as power generation, real estate, manufacturing, automotive and agriculture. These exposures may be offset by financing green initiatives, which have the potential to mitigate transition risk across a portfolio, increase profit and, better yet, stabilize balance sheets as the economy evolves into a carbon neutral world.