Kevin Stiroh: Climate change and risk management in bank
supervision
Remarks by Mr Kevin Stiroh, Executive Vice President of the Financial Institution Supervision
Group of the Federal Reserve Bank of New York, at the conference on "Risks, Opportunities, and
Investment in the Era of Climate Change", Harvard Business School, Boston, Massachusetts, 4
March 2020.
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As prepared for delivery
Introduction
Good afternoon and thank you for the opportunity to participate in this conference on "Risks,
Opportunities, and Investments in the Era of Climate Change," a topic of critical importance for
all of us.
Climate change is already affecting economic and financial outcomes, and projections point to
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increasingly severe and unpredictable change. In recent years, we've seen a growing focus of
central banks on the financial risks related to climate change. Some may argue that this shift
was slow in coming, but the change is striking nevertheless. Beginning with Bank of England
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Governor Mark Carney's speech in 2015 , climate change has emerged as a key issue globally.
Within the Federal Reserve, Governor Brainard detailed how climate change impacts the Fed's
core objectives around monetary policy, financial stability, financial regulation and supervision,
community and consumer affairs, and payments and describes efforts to build capacity to
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assess these risks.
Today, I'm going to take a more narrow perspective and talk about climate change from the
perspective of risk management. I'll discuss how the development of new risks associated with
climate change is beginning to change the practice of risk management at financial institutions in
terms of governance, risk identification and management, scenario analysis and transparency. I'll
also say a few words on why I believe it is appropriate, even critical, for supervisors to focus on
this particular risk.
Before proceeding, I will emphasize that I am speaking for myself and my views do not
necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve
System.
Climate Change and Risk Management
The discussion of climate change and risk management has introduced a new lexicon for risk
discussions. Physical risk is the potential for losses as climate-related changes disrupt business
operations, destroy capital and interrupt economic activity. Transition risk is the potential for loss
resulting from a shift toward a lower-carbon economy as policy, consumer sentiment and
technological innovations impact the value of certain assets and liabilities. These effects will be
felt across business sectors and asset classes, on strategies and operations, and through the
balance sheets and income statements of financial firms.
At a practical level, risk managers at financial institutions need to develop the appropriate tools to
identify, monitor and manage these risks. From one perspective, climate-related risks may
manifest as realizations of familiar risks such as credit, market, operational, legal and
reputational risk. The tools risk managers use, however, will need to change to reflect new data,
changing relationships, and evolving interconnections. Traditional backward-looking models
based on historical trends may no longer be reliable, so the development of forward-looking
approaches grounded in scenario-based analyses may be necessary. Perhaps even more
importantly, physical and transition risks will likely introduce new strategic risks associated with
the challenges and opportunities of sectoral reallocations of economic activity, new production
patterns and evolving industry exposures.
Range of Practices
Given these emerging risks, what are large financial institutions actually doing to identify, monitor,
and manage them? This is a new and rapidly evolving field, so we are far from coalescing around
best practices or industry standards. Nevertheless, some emerging themes are emerging from
the largest, most complex financial institutions. I will touch on governance, risk identification and
management, scenario analysis, and transparency.
I'll begin with governance. Boards of directors and senior management are increasingly attuned
to the risks posed by climate change as pressure from various stakeholders intensifies. For
example, some firms are establishing internal climate-related working groups to develop
enterprise-wide climate frameworks and to ensure climate considerations such as geographic
concentrations or regulatory changes are better integrated into strategic decision-making. Some
senior leaders are discussing risk materiality in geographic and sectoral reviews and results of
forward-looking climate scenario analyses. Few firms, however, have formally modified or
qualified enterprise-wide risk appetite statements to acknowledge climate to date, although some
are considering this. Based on our observations, information flows and detailed climate reporting
appear more prevalent at the management committee level rather than boards of directors.
In terms of risk identification and management, some firms are beginning to assess how gradual
changes in climate impact operational resilience and the potential for business disruption.
Several conduct periodic disruption simulations with predictive weather modeling as part of their
resiliency programs. This work builds on experience managing risks posed by disaster events,
including severe weather, to their operations and infrastructure such as branches, equipment
and data centers. This includes updating disaster response playbooks and business continuity
plans to address the resultant operational risks.
In terms of credit and market risk, some firms are building ex-ante climate risk assessments into
sectoral or industry reviews, while others are considering the role of climate change within
traditional ex-post assessments of exposures and loss estimates related to severe weather
events like wildfires, hurricanes, and flooding. Examples include: heightened monitoring of
mortgage concentrations in high-risk areas, modified risk limits or reduced tenors for
transactions to certain carbon-intensive sectors, and consideration of climate risk disclosures in
offering documents.
Climate-related scenario analysis is an emerging practice at multiple firms to identify lending
portfolio sensitivity to both physical and transition risks. For physical risk scenarios, this might
include stressing mortgage lending in discrete geographies against both publically available
natural hazard scenarios and internally generated severe weather simulations. For transition risk
scenarios, some firms are using their energy lending portfolios as a starting point to model
transition mechanisms. Additionally, some firms are considering how to expand analysis to more
indirectly impacted sectors, such as transportation and industrials, or to move beyond lending
exposures to trading positions.
Finally, firms are evaluating how to best execute on public commitments to transparency in the
climate space. Nearly all global systemically important banks, including all eight U.S. G-SIBS,
have signed onto the Task-Force for Climate-Related Financial Disclosures (TCFD), and many
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of these have started disclosing under this framework to various extents. Firms continue to be
challenged in the identification and measurement of climate risk embedded in their portfolios,
however, so these disclosures may take some time to develop as the industry considers how to
establish common standards.
Role of Supervision
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I'll turn now to the perspective of a bank supervisor. In the context of climate change, in my view,
bank supervision should focus on ensuring that appropriate risk management frameworks are in
place, rather than using supervisory tools for broader objectives. That is, supervisors can focus
on identifying and managing risks, both microprudential and macroprudential, that emerge along
a transition path to a more sustainable economy. Bank supervisors, however, are not in the
position to advocate for, or provide incentives for, a particular policy outcome. Those broader
policy goals are the purview of elected officials and governments, and policymakers. Supervisors
can and should use our oversight tools to ensure financial institutions are prepared for and
resilient to all types of relevant risks, including climate-related events.
From that perspective, climate change introduces challenges for supervisors related to time
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horizon, data limitations, and inherent complexity. One question that gets particular attention
centers on time horizon and prioritization. More specifically, given the many risks that financial
firms face-cybersecurity, geopolitical uncertainty, and the credit cycle to name a few-and the
relatively long time horizon around climate change, why should supervisors focus on this
particular risk? I think that is a fair question and there are good answers.
First, we are already observing the impacts of climate change on financial firms. Evidence
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continues to grow that climate change is affecting economic and financial outcomes. Moreover,
evidence from climate science suggests that some further physical climate impacts are
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lockedin due to past emissions. Some investors consider an assessment of sustainability to be
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integral to their fiduciary responsibilities. And, as I described earlier, supervised firms are
choosing to build capacity in this areas, so supervisors need to understand and assess these
changes. This is a risk management question for today with direct implications for safety and
soundness.
Second, given the complexity of the problem, we all need time to build data, models, and
intellectual capacity to address risks as they arise in the future. It took the better part of a decade
to approach a steady-state in central bank stress testing capabilities for more familiar and
arguably less complex risks like credit card losses or shocks to asset values from interest rate
spikes. The economics of climate change are more complex with feedback effects,
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nonlinearities and massive uncertainty that will require substantial investments to understand.
Third, financial markets and institutions face the potential for a "Minsky moment" related to
climate change-an abrupt repricing of assets in response to a catastrophic event or change in
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investor perceptions. Financial firms and supervisors need to consider the potential and impact
of this type of sudden event.
Conclusion
In closing, the impact of climate change on the structure and performance of the economy and
the financial sector is happening now and will continue. Conferences like this certainly help to
further our awareness and understanding of this critical issue. I am confident that risk managers
and central banks will continue to invest and build capacity to understand and mitigate these
risks in order to make the financial sector more resilient.
I look forward to hearing the insights from across the financial sector in the remainder of this
conference.
Thank you for your attention.
U.S. Global Change Research Program, "Fourth National Climate Assessment: Volume II: Impacts, Risks and
Adaptation in the United States," Washington USGCRP, 2018.
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Governor Mark Carney, Bank of England, "Breaking the Tragedy of the Horizon - Climate Change and Financial
Stability", Sept. 2015.
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Governor Lael Brainard, Federal Reserve Board of Governors, "Why Climate Change Matters for Monetary Policy
and Financial Stability", Nov. 2019.
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Patrick Bolton, Morgan Despress, Luiz Awazu Pereira da Silva, Frederic Samama, and Romain Svartzman, "The
Green Swan - Central Banking and Financial Stability in the Age of Climate Change," Bank for International
Settlements, 2020.
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TCFD site and review of annual reports, integrated reports, non-financial reports, sustainability reports and
standalone climate-related disclosure reports of individual GSIBs.
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In the international context, see Enhancing Banks' and Insurers' Approaches to Managing the Financial Risks
from Climate Change, Bank of England Supervisory Statement 3/19, April 15, 2019; ECB Banking Supervision:
Risk Assessment for 2020, European Central Bank; and Bolton et al. (2020).
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Kevin J. Stiroh, New York Fed, Emerging Issues for Risk Managers, Nov, 2019.
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Governor Lael Brainard, Federal Reserve Board of Governors, Why Climate Change Matters for Monetary Policy
and Financial Stability, Nov. 2019.
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"Demystifying Climate Scenario Analysis for Financial Stakeholders," Four Twenty Seven, 2019. "Climate risk
and response," McKinsey Global Institute, 2020. "Fifth Assessment Report (AR5), the Synthesis Report (SYR),"
Intergovernmental Panel on Climate Change (2015).
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Fink, Larry, A Fundamental Reshaping of Finance, Letter to CEOs, 2020.
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See The 2021 Biennial Exploratory Scenario on the Financial Risks from Climate Change, Bank of England
Discussion Paper, December 2019 for a discussion of relevant issues.
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Carney (2015).