The Guidance would increase expectations for regulated financial institutions to identify, measure, monitor, and control climate-related financial risks.
For the past few years, the New York State Department of Financial Services (DFS) Superintendent has prioritized setting the pace in climate risk management for financial institutions that it supervises. On December 21, 2022, the DFS proposed Guidance for New York State-Regulated Banking and Mortgage Institutions Relating to Management of Safety & Soundness Risks from Climate Change (the Guidance). The Guidance follows on the DFS’ October 2020 letter to CEOs of its regulated financial institutions, which announced that DFS was developing a strategy for integrating climate-related risks into its supervisory mandate. The letter also announced that DFS would engage with banking organizations (and coordinate with US and international counterparts) to develop effective supervisory practices and guidance to mitigate the financial risks from climate change.
The Guidance aims to support efforts by New York State-regulated banking and mortgage institutions (including branches and agencies of non-US banks under its jurisdiction) to identify, measure, monitor, and control “material” climate-related financial risks, consistent with existing risk management principles.
Regulated institutions are expected to take a “proportionate approach” to managing climate-related risks, based on factors such as size, complexity, geographic distribution, business lines, exposure, and investment strategies of their businesses. A regulated institution’s assessment of materiality may be based on the nature, scale, and complexity of its business, and foreign banking organizations may take into account home-country regulators’ requirements, as appropriate.
Key Focus Areas
The Guidance addresses both the physical and transition risks associated with climate change and focuses on the following components of prudent risk management and operational resilience. New York State-regulated banking and mortgage institutions should:
- Corporate Governance: Establish a process for identifying, measuring, monitoring, and controlling the organization’s financial risks associated with climate change, in the short, medium, and long term, for each business unit and product line. Boards and management should have adequate understanding and knowledge to assess climate-related financial risks and their impact on the overall risk appetite of the organization. Integrate climate-related financial risks into the organization’s risk appetite framework, as well as policies, procedures, and controls across all relevant functions and business units.
- Internal Control Framework: Incorporate climate-related financial risks into internal control frameworks across the three lines of defense (front office/risk-taking, risk management and compliance, and internal audit), to ensure sound, comprehensive, and effective identification, measurement, monitoring, and control of material climate-related financial risks.
- Risk Management Process:
- Identify how physical and transition risks may impact specific asset classes, sectors, counterparties, or geographical locations
- Develop appropriate key risk measurement tools or indicators for effective management of material climate-related financial risks as part of existing risk measurement systems
- Monitor risk positions and exceptions to operating within established policies, limits, and risk appetite
- Establish, implement, and regularly review plans to mitigate and manage exposure to material climate-related financial risks
- Data Aggregation and Reporting: Develop risk data aggregation and reporting capabilities that support adequate monitoring of material climate-related financial risks, and production of information to facilitate management decision-making.
- Scenario Analysis:
- Consider using a range of climate scenarios to assess the resiliency of business models and strategies
- Identify and measure vulnerability to relevant climate-related risk factors
- Estimate exposures and potential impacts
- Determine the materiality of climate-related financial risks
Fair Lending and Equity Goals
The Guidance reminds financial institutions to be aware of effects on low- and moderate-income and at-risk communities when updating risk management frameworks to account for climate-related financial risks. At a minimum, institutions must adhere to consumer protection laws (including fair lending considerations) when managing climate-related financial risks. But the DFS also expects regulated institutions to actually “minimize and affirmatively mitigate adverse impacts” of climate change on at-risk communities. This may narrow the realm of acceptable behavior for regulated institutions, as they balance their duty to manage climate-related financial risks with their duty of fair lending, particularly in instances in which climate risk assessments have indicated greater risks in marginalized communities. The Guidance refers regulated institutions to the DFS Industry Letter “CRA Consideration for Activities that Contribute to Climate Mitigation and Adaptation” for additional details on balancing these considerations.
Approach for Non-US Banking Organizations
Branches or agencies of foreign entities under DFS jurisdiction would need to maintain oversight functions, policies and procedures, and information systems in such a way that they are transparent to US regulatory oversight. Notably, management of such non-US entities should apprise head offices of regulatory expectations and obligations that may be applicable to US operations, from both federal and applicable state regulators. Non-US banks operating a US banking business would therefore need to consider the Guidance in light of their wider climate-related financial risk frameworks. However, their US senior management would also be required to “demonstrate and maintain a thorough understanding” of all relevant risks affecting US operations as well as the associated management information systems used to monitor and manage those risks. Non-US banks would therefore need to manage an increasingly complex, and possibly at times divergent, set of expectations from federal, state, and home country regulators.
Key Difference Versus Federal Proposals
On December 2, 2022, the Board of Governors of the Federal Reserve System (Federal Reserve) published proposed Principles for Climate-Related Financial Risk Management for Large Financial Institutions. The Federal Reserve proposal would only apply to large financial institutions, defined as those with over $100 billion in assets that are subject to Federal Reserve supervision, including the US operations of non-US banking organizations. (See this Latham blog post for more information).
The Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) issued a similar climate risk proposals on December 16, 2021 (see here) and March 30, 2022 (see here), respectively, and those proposals would also apply only to large financial institutions with more than $100 billion in total consolidated assets.
The DFS Guidance states that “the objective of this supervisory guidance is consistent with interagency guidance implemented by federal banking regulators.” However, the Guidance would apply to New York State-regulated banking and mortgage institutions of all sizes, not just large financial institutions. The Guidance justifies this tack by stating that “smaller organizations are not necessarily less exposed to climate-related financial risk, because they may have concentrated business lines or geographies that are highly exposed to climate-related financial risks without the risk-mitigating benefit of diversification available to larger organizations.”
Financial institutions that are publicly listed in the United States would also need to consider how compliance with the guidance may affect obligations under the Securities and Exchange Commission’s climate disclosure proposal (the SEC Proposal). The SEC Proposal includes several disclosure requirements that apply only if registrants take certain actions, including regarding scenario analysis, and the DFS Guidance may require additional disclosure controls as a result. (For more information on the SEC Proposal, see Latham’s prior analyses here and here.)
Comparison to Other US States
In a recent interview, DFS Superintendent Adrienne Harris said she was hopeful that the Guidance would avoid ideological controversies and “become a model for other states,” regardless of their political affiliations. However, various states have taken different positions on the consideration of climate change and other environmental, social, and governance (ESG) factors in financial institutions’ decision-making. Several states — including Texas, West Virginia, and Kentucky — have enacted laws restricting the provision of government funds, such as through service contracts or investments, to financial institutions that are deemed to “boycott” certain sectors, namely fossil fuels. These laws have resulted in various financial institutions being barred from investment or participation in certain government contracts (though the selection of financial institutions for these lists seems to vary between states).
Additionally, Florida plans to pursue other punitive policies for financial institutions looking to proactively consider certain ESG factors in their capital allocation decisions. Governor Ron DeSantis previously indicated plans to introduce legislation in the 2023 session to amend Florida’s Deceptive and Unfair Trade Practices statute to prohibit “discriminatory practices by large financial institutions based on ESG social credit score metrics.” While proposed legislation remains outstanding, financial institutions could be required to comply with contradictory mandates to the extent certain states where they are licensed require consideration of certain ESG matters, such as climate and other ESG risks while others prohibit their consideration.
The Guidance is in the proposal phase, and the DFS is seeking stakeholder feedback by March 21, 2023. Key questions include:
- feedback on a potential timeline for implementation;
- scenario analysis considerations for smaller institutions; and
- potential reporting requirements on regulated institutions for material financial risks from climate change.
As indicated above, federal regulatory agencies and other states are taking a variety of actions. As such, potentially affected financial institutions should review their policies now for the implications of the requirements and guidance being issued, or other actions being taken, by federal and state actors so that they can consider any changes to their strategies accordingly.