On April 29, 2022, the Financial Stability Board (“FSB”) released an interim report on “Supervisory and Regulatory Approaches to Climate-Related Risks” (the “Report”).1 The Report contains recommendations for banking and insurance regulators to oversee climate-related financial risks at the country-wide and institution levels. It examines supervisory and regulatory practices for reporting and aggregating climate-related data from financial institutions, explores supervisory and regulatory approaches to assessing climate-related risks and assesses the extent to which current policies and tools address climate-related risks.
The FSB has requested comments on the interim Report in anticipation of releasing a final report at a later date. In particular, the FSB has asked for comments on several questions, which include whether the report appropriately highlights the most important and relevant information and whether the FSB’s recommendations are helpful. The deadline for comments is June 30, 2022.
In this Legal Update, we highlight key points from the Report and discuss important takeaways for US financial institutions.
The FSB is an international, intergovernmental entity that monitors and makes recommendations about the global financial system. It was formed in 2009 by the heads of state and government of the Group of Twenty (“G20”)—the 20 countries with the world’s largest economies—as a successor to the Financial Stability Forum (“FSF”). The FSB was formed in the wake of the 2008 financial crisis as a stronger institution than the FSF and with an expanded membership. Today, the FSB’s members consist of international bodies and senior policy makers from central bank and supervisory and regulatory authorities for the G20 countries and Hong Kong, Singapore, Spain, and Switzerland.
The FSB serves as a forum for its members to assess financial risks and propose standards to limit risks to financial stability. It does so by identifying systemic risk in the financial sector, framing financial sector policy actions that can address identified risks, and overseeing implementation of those responses. The FSB’s purposes specifically include, among other things, assessing vulnerabilities affecting the global financial system, promoting coordination and information exchange among authorities responsible for financial stability, and monitoring and advising on market developments.
The Report seeks to help supervisory and regulatory authorities that are part of the FSB develop a consistent approach to addressing climate-related risks globally. Through a more consistent approach, the FSB believes that authorities will be better able to assess and mitigate financial vulnerabilities and reduce the risk of market fragmentation. The Report focuses on the cross-sectoral and system-wide aspects of climate-related financial risks. In other words, the Report mainly concentrates on macroprudential objectives, such as monitoring vulnerabilities and their implications to financial stability and sector- and jurisdiction-level scenario analysis and stress testing. However, the Report does address some microprudential objectives, i.e., institution-specific strategies and risks such as the viability of institutions’ business models.
In the Report, the FSB highlights that climate scenario analysis and stress testing have been the main tool used to address the coverage of climate-related risks, and primarily physical risk and transition risk. Physical risk includes, for example, severe weather events and sea-level rise. Transition risk includes technological developments that may make less environmentally friendly technology obsolete, consumer and investor demands for more environmentally sustainable products and services, and governmental changes intended to shift to a lower-carbon economy. The Report notes generally that, across sectors, the level of coverage for transition risk is slightly higher than for transition risk.
Importantly, the Report states that the use of climate scenario analysis and stress tests is currently more common for the banking and insurance sectors than the asset management and pension fund sectors. Therefore, the asset management and pensions sectors may want to consider the potential for further regulation in this area in the future.
The Report is divided into three sections: (i) supervisory and regulatory collection of climate-related data from financial institutions, (ii) system-wide supervisory and regulator approaches to assessing climate-related risks and (iii) the extent to which current policies and tools address climate-related risks. We discuss each section in more detail below.
Reporting and Collection of Climate-Related Data
In the Report’s first section, the FSB acknowledges that many financial institutions and regulators have cited the lack of sufficient climate data as a major challenge to developing approaches to address climate-related risks. The Report examines the current regulatory and supervisory practices on the reporting and collection of climate-related data from financial institutions. In addition, the Report identifies types of data and metrics that entities may require and provides examples of industry practices on these metrics. The Report also discusses the reliability of climate-related data and identifies common elements for a high-level definition of climate-related risks.
Highlights of the section include the following:
- Significantly, the Report identifies three types of climate risks: physical risk, transition risk and liability risk. Most US definitions of climate risk typically only include physical and transition risk. The FSB adds liability risk, which can result from manifestations of physical and transition risk but can also materialize separately. Liability risks include potential financial losses stemming from legal claims. The FSB raises concerns about liability risks in the Report, highlighting that authorities may want to consider issuing a clear definition of liability risk, even if it is considered a subset of physical and transition risks.2
- The Report also discusses the collection of information about climate-related risks and the need to standardize that information. The FSB notes that authorities may want to consider implementing a system-wide reporting structure that can facilitate compiling data across sectors, aggregating data and metrics, and monitoring cross-sectoral risks and systemic risks.
Aspects of a System-Wide Regulatory and Supervisory Approach to Climate-Related Risks and the Use of Analytical Tools
The Report’s next section discusses why a system-wide perspective of climate-related risks is important, the key elements of system-wide supervisory and regulatory tools and policies, and authorities’ approaches to date. The Report states that risk assessments and policies need to better incorporate an understanding of how climate-related risks to financial institutions may be transferred across sectors or borders. The FSB reported that the primary tools for capturing transition and physical risk have been climate scenario analysis and stress tests; however, authorities are starting to expand their approaches by looking at risks in the aggregate and factoring in system-wide aspects. Authorities who have started to adopt a system-wide perspective have incorporated practices such as top-down exercises combined with bottom-up elements involving financial institutions, dynamic balance sheet assumptions and common scenarios.
The section also discusses analytical tools for a system-wide perspective, focusing on macroprudential measures that can supplement microprudential tools. The Report discusses existing literature and the work to date of standard-setting bodies and authorities on such macroprudential policies and tools, as well as trade-off considerations. The FSB encourages authorities to undertake research and analysis on appropriate enhancements to regulatory and supervisory frameworks.
One highlight of this section addresses current practices and trends in scenario analysis and stress testing. The FSB suggests that the nature of climate risks may require substantial modifications to a traditional macroprudential stress test framework. The Report points out that many jurisdictions have developed or are developing new climate stress test frameworks or are improving existing methodologies to incorporate second-round effects. Accordingly, the Report appears to envision a more robust approach to stress testing that could impose binding constraints on institutions.
Extent to Which Regulatory and Supervisory Tools and Policies Address Climate-Related Risks
The Report’s final section summarizes key findings on the extent to which tools and policies currently used or planned to be used by jurisdictions account for the specificities of climate-related risks. These findings include how, and to what extent, the tools and policies address systemic risks as well as capture physical and transition risk. The Report proposes several recommendations on expanding climate scenario analysis and stress tests to incorporate systemic risks. Further, the Report introduces potential macroprudential policies and tools to address systemic risks that may not be addressed fully by current measures.
One highlight of this section is that the FSB makes several suggestions on macroprudential tools that authorities may consider using to address system-wide climate-related risks. These tools include principle-based supervisory expectations and capital requirements. Specifically, the FSB discusses concentration limits on portfolios, large exposure limits, and capital buffers. All of the suggested macroprudential tools would likely be controversial in the United States. Indeed, only three months before the Report was published, the US Secretary of the Treasury, Janet Yellen, stated that it is too early to consider adjusting capital requirements for US banks based on climate change-related risks. Secretary Yellen did not completely discount the possibility of such requirements in the future but indicated that regulators must first conduct further research to evaluate risks to individual institutions.3
Takeaways for US Financial Institutions
The Report adds to the other signals that prudential regulators globally, including US regulators, may take action to strengthen regulations and oversight of climate-related financial risks, particularly with regard to cross-sectoral and system-wide risks. US regulators—such as representatives from the Federal Reserve System and the Department of the Treasury—are all members of the FSB and may propose implementing at least some of the Report’s recommendations in the United States.
Further, one significant takeaway from the Report is that the United States may be lagging behind other FSB members with respect to addressing climate-related financial risks. None of the examples of policies, tools, or measures cited in the Report are from the United States. The lack of US examples in the Report, and the general progress of many of the other G20 countries, could further encourage US regulators to consider implementing some of the Report’s recommendations sooner rather than later. Accordingly, US financial institutions should expect more regulation of climate-related risks as the United States catches up to other countries that have implemented significant measures for addressing climate-related risks.
Finally, the Report emphasizes the lack of comprehensive and standardized data on climate-related financial risks, which is needed to both assess and manage climate risk. Many in the United States have raised this as a concern, and some have noted that even institution-specific data may be insufficient. Some regulators may seek to collect this information through new reporting requirements, but financial institutions will need time to develop the expertise and capabilities to capture this information. While standardization through reporting requirements could facilitate greater interoperability and anonymized sharing arrangements, regulators will need to be sensitive to the burden that such requirements have on the industry and work collaboratively with institutions. This will help to ensure that climate risk processes use data that reflects material factors, do not constantly change for the latest fad, and are not overly burdensome for the financial sector. We expect this to be a key area for comments on the Report, which again, are due by June 30, 2022.
1 FSB, Supervisory and Regulatory Approaches to Climate-Related Risks Interim Report (Apr. 29, 2022), https://www.fsb.org/wp-content/uploads/P290422.pdf.
2 The FSB’s concerns regarding liability risks are consistent with those of other international organizations. For example, in November 2021, the Network for Greening the Financial System released a report on the increasing risk of climate-related litigation. See NGFS, Climate-related litigation: raising awareness about a growing source of risk (Nov. 5, 2021), https://www.ngfs.net/en/climate-related-litigations-raising-awareness-about-growing-source-risk.
3 See Christopher Condon, Janet Yellen Says Higher Bank Capital Rules for Climate Risk are “Premature,” Bloomberg (Feb. 2, 2022), https://www.bloomberg.com/news/articles/2022-02-02/yellen-says-higher-bank-capital-rules-for-climate-premature.