OCC Draft Principles Outline How Banks Should Address Climate Related Financial Risk

On December 16, 2021, the Office of the Comptroller of the Currency (OCC) requested feedback on its draft principles addressing climate-related financial risk. The draft principles are designed to support the identification and management of climate-related financial risks at OCC-regulated institutions with more than $100 billion in total consolidated assets¹. Given that regulators are talking to each other and working together in today’s current environment, these principles should be a good indicator for all financial institutions as to where regulators are heading. The OCC is accepting feedback through February 14, 2022, after which it will release updated principles that will be used as a foundation for future climate-related financial risk guidance.

Summary

The OCC’s draft principles² are in response to its identification of the effects of climate change and the transition to a low-carbon economy as emerging risks to banks and the financial system. The OCC states that banks and the financial system are likely to be impacted by the physical and transition risks from climate change³. The principles endeavor to address potential weaknesses in banks’ approach to identifying, measuring, monitoring, and controlling climate-related financial risk as they look to protect the overall financial system. Adverse effects to the financial system would impact everyone, but, as history has shown, would likely disproportionately impact the financially vulnerable or low-to-moderate-income (LMI) households and communities.

The draft principles build on existing OCC rules and guidance and assist banks in developing a framework to support safe and sound management of climate-related financial risks. Specifically, they:

1. Support banks’ efforts to focus on key aspects of climate-related financial risk management
2. Provide a high-level framework⁴ for climate-related financial risk management consistent with existing OCC rules and guidance

The Draft Principles

The OCC outlined six core principles banks need to be aware of:

Governance: Banks need effective risk governance frameworks, and management teams should have an understanding of climate-related financial risk. This includes allocating appropriate resources, assigning climate-related financial risk roles and responsibilities throughout the organization (i.e., committees and reporting lines), reviewing necessary information to oversee the bank, and clearly communicating to staff the climate-related impacts to the bank’s risk profile.

Policies, Procedures, and Limits: The bank’s approach to risk management policies, procedures, and limits should include climate-related risks and be monitored and modified as necessary.

Strategic Planning: The bank’s overall business strategy, risk appetite, and financial, capital, and operational plans can be impacted by climate-related financial risk. It can impact the bank’s business objectives, stakeholders’ expectations, the bank’s reputation, operations, financial condition, as well as LMI   and other disadvantaged households and communities. The OCC understands strategic planning is an iterative process and it will be updated from time to time.

Risk Management: The bank should have sound processes to identify, measure, monitor, report, and control climate-related financial risk exposures within the bank’s existing risk management framework. Banks should constantly review emerging risks stemming from business activities and other exposures. These risks must be clearly defined within the risk management framework and supported by appropriate metrics. The OCC recommends banks use “tools and approaches for measuring and monitoring exposure to climate-related risks includ[ing] exposure analysis, heat maps, climate risk dashboards, and scenario analysis.”

Data, Risk Measurement, and Reporting: Banks should have access to relevant, accurate, and timely data when analyzing climate-related financial risk. Further, climate-related financial risk information should be built into internal reporting, monitoring, and escalation processes. Accurate and timely information allows management teams to make educated decisions when assessing the impact climate-related financial risk would have on their bank.

Scenario Analysis: The OCC refers to climate-related scenario analysis⁵ as “exercises used to conduct a forward-looking assessment of the potential impact on a bank of changes in the economy, financial system, or the distribution of physical hazards resulting from climate-related risks.”  These exercises assess and provide a comprehensive and forward-looking perspective to structural changes arising from climate-related risks. A scenario analysis could help by:

• Exploring the impacts of climate-related risks on a strategy and business model
• Identifying and measuring vulnerability to physical and transition risks
• Estimating climate-related exposure and potential losses for multiple scenarios
• Assisting in identifying data and methodological limitations and uncertainty in climate risk management
• Informing the adequacy of the bank’s climate risk management framework⁶

Management of Risk Areas

The OCC principles are also designed to assist banks with improving their risk governance framework. The principles will provide support to banks identifying emerging climate-related risks and developing and implementing appropriate strategies to mitigate those risks. The OCC highlighted six areas of climate-related financial risk:

Credit Risk: Risk to existing underwriting policies and procedures, as well as ongoing monitoring of portfolios. Banks should monitor climate-related credit risks through sectoral, geographic, and single-name concentration analyses, including credit risk concentrations stemming from physical and transition risks. As part of concentration risk analysis, management should assess potential changes in correlations across exposures or asset classes.

Liquidity Risk: Risks to a bank’s liquidity buffers as well as incorporating those risks into liquidity risk management.

Other Financial Risk: Risk to exacerbate potential interest rate risk and other model inputs for greater volatility or less predictability. While there is no clear strategy for measuring climate price risk within the markets, the board and management should use the best measurement methodologies reasonably available.

Operational Risk: Risk to a bank’s operations, control environment, and operational resilience. A bank needs sound operational risk management across all business lines and operations, including third-party operations.

Legal/Compliance Risk: Risks may impact the legal and regulatory landscape for banks⁷. The OCC hypothesizes there could be changes to “legal requirements for, or underwriting considerations related to, flood or disaster-related insurance. It also includes possible fair-lending concerns if the bank’s risk mitigation measures disproportionately affect communities or households on a prohibited basis such as race or ethnicity.”

Other Non-Financial Risks: Risks to strategic decisions and operating environment of banks. The board and management should actively consider which of the bank’s activities may increase the impact of climate-related financial risk as it relates to the bank’s reputation, liability, or litigation.

Key Considerations

While the OCC is focusing on banks with more than $100 billion in assets, all banks should consider aligning to the proposed principles and implement necessary changes to ensure they are in a position to manage climate-related risk. Entities should consider proactively assessing their exposure based on the draft principles and review the areas of risk highlighted by the OCC as they relate to the entities’ existing risk management framework. This includes identifying and assessing any climate-related enterprise risks not included in their framework that could inhibit compliance with the proposed principles.

How Guidehouse Can Help

Guidehouse can help banks and management teams assess their risk management frameworks in light of the draft principles proposed by the OCC.

Guidehouse has a deep bench of financial services and climate and energy professionals with decades of public and private sector experience and a strong understanding of the climate environment in which financial institutions operate. Among other capabilities, Guidehouse can quickly review and assess your risk management frameworks to determine whether it is sound, identify gaps or weaknesses, and provide recommendations to ensure it aligns with the OCC’s draft principles. Guidehouse is well-equipped to make an individualized assessment of your unique circumstances and offer innovative advice and solutions for responding to potentially heightened regulatory requirements.

Co-authored by Henry Darmstadter.