US climate guidance stokes debate over defining material risks

Banks welcome flexibility, but it could lead to big divergence on climate risk management

New US regulatory guidance on climate risks could still leave room for wide divergence on risk measurement and management, according to experts.

“They’ve left it fairly open as to exactly how the capital impact should be incorporated, and they’ve left it to the banks to determine those rare cases where there’s a significant expected short-term loss,” says the head of climate risk at a global bank.

The Office of the Comptroller of the Currency (OCC), Federal Reserve and Federal Deposit Insurance Corporation all consulted separately on principles for managing climate risk during 2021 and 2022. They finalised a joint set of principles in October 2023 – much to the relief of the banking sector, which had called for a co-ordinated approach between the three regulators. The principles will apply to all banks with more than $100 billion in consolidated assets.

In keeping with the original draft guidelines from the individual agencies, the inter-agency principles cover governance, risk limits and reporting, strategic planning and scenario analysis. They also encompass all risk categories – credit, market, operational, liquidity and interest rate risks.

They’ve left it fairly open as to exactly how the capital impact should be incorporated

Head of climate risk at a global bank

“The US authorities have a different starting point from the European authorities – and even some others, say in Asia – that have mandates more directly slated to support the overall political objectives of their jurisdiction, obviously including a transition [to net zero],” says a head of sustainability at a second global bank.

Crucially, the guidelines give banks discretion on how to identify and manage risks that may be material, provided their methodologies are consistent with those they use to identify other types of emerging risks. 

This result is in line with the hopes of industry lobbyists. In its February 2022 response to the original OCC consultation, the Bank Policy Institute asked for regulators to “clarify that for purposes of risk management, individual banks will need to define “materiality” in the context of their individual circumstances and risk appetite framework”.

A senior climate risk manager at a US global systemically important bank (G-Sib) says the principles-based approach taken by US regulators is “incredibly helpful”, because it allows individual banks to focus on their material areas of exposure. Since the banks had already made decisions about how to treat climate risk, they were hoping for guidelines that would allow them to adapt their existing framework, rather than having to rebuild it.

“The supervisory expectations confirm decisions that we’ve made and identify areas where we have more work to do,” says the climate risk manager. “We found it very helpful to see a principles-based approach which allows us to make sure we are focused on the most material areas of exposure for our business, recognising that there are quite a lot of capabilities that we now want to build over time.”

Choose your own scenario

However, the principles may still lead to banks taking very different approaches to climate risk management. Bankers at three firms who spoke to Risk.net have diverging opinions on how to define and measure materiality.

The head of climate risk at the first global bank suggests using scenario analysis to assess expected loss or an impact on risk weighted assets (RWAs). Banks can then compare climate scenarios with other types of shock scenarios to show they are taking a consistent approach to determining materiality.

“You can use those standard techniques to compare with other material impacts and set a threshold for expected loss or RWA impact,” the climate risk head says.

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They are much more sceptical about the regulators’ suggestion that scenario analysis can also be used to analyse data and methodological limitations in a bank’s existing climate risk framework. 

“You have data and methodological limitations across the board with reference to managing climate risks, so I’m not sure how running a scenario will help you realise what those limitations are across the rest of the framework,” the head of climate risk says.

The climate risk manager at the US G-Sib agrees there are existing capabilities they can use, such as credit default models. But they will also need to develop techniques such as Monte Carlo-style analysis to translate the broad macroeconomic climate risk scenarios into more granular impacts and hotspots on specific portfolios.

“You want to be able to assess under a specific scenario what happens – for example, within the agricultural sector – to your lending to a farmer in California versus a farmer in Indonesia,” says the climate risk manager. “That’s informing the new modelling capabilities we have to build.”

Data demands

Across the board, there is a sense that regulators have not fully taken into account the difficulties sourcing relevant data for climate risk management. The preamble to the final principles acknowledges that respondents to the original consultation had expressed concerns about “data- and modeling-related challenges”, but banks don’t feel there is much recognition of this in the guidelines themselves.

There’s no complete data at all. This is something the whole industry is struggling with

Head of climate risk at a global bank

The principles emphasise that “timely, accurate, consistent, complete, and relevant data” is necessary for sound climate-related financial risk management. Banks fear this is very demanding given what the head of climate risk at the first global bank calls “really significant challenges” around data availability.  

“Accurate? That’s really difficult. Complete? There’s no complete data at all,” says the head of climate risk. “This is something the whole industry is struggling with.”

They say banks will also be “very challenged” by US regulators’ expectations that scenarios are subjected to data and quality control standards commensurate with the bank’s risk. This means developing model validation standards similar to those used for the existing risk categories.

“Validation is very tough,” says the head of climate risk. “Some of your normal validation techniques are not available – you can’t do back testing, because the whole expectation is that things are going to be different in the future to in the past.”

Moreover, US regulators have introduced novel requirements that go well beyond any international standards such as those produced by the Basel Committee on Banking Supervision. The inter-agency principles incorporate the concept of double materiality, requiring banks to consider the impact of climate risk mitigation on low- and moderate-income consumers and communities. Banks should ensure that “lending monitoring programs review whether and how the financial institution's risk mitigation measures potentially discriminate against consumers on a prohibited basis, such as race, colour, or national origin,” the principles say.

“That is a new concept, and it’s also not entirely clear how you would go about doing that and how financial institutions would apply that,” says a head of sustainability at the second global bank.

Editing by Philip Alexander