Federal Reserve Recognizes Significance of Climate Risks on Financial Stability

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Latham & Watkins LLPThe US prudential regulator is paying attention to climate risks, and will likely act to mitigate those risks if they threaten financial stability.

In its November 2020 Financial Stability Report (the Report), the Board of Governors of the Federal Reserve System (Federal Reserve) acknowledged, for the first time in the Report’s history, the impact of climate risks on financial stability. The Report, which aims to provide a current assessment of the resilience of the US financial system on a biannual basis, reflects Chairman Jerome Powell’s November 5, 2020, statement, in which he said that the Federal Reserve is “actively … getting up to speed” on climate risks and impacts to the financial system.

The biannual Report follows a September 9, 2020, report from the Commodity Futures Trading Commission’s (CFTC’s) Climate-Related Market Risk Subcommittee, which focuses on the systemic threat that climate change poses to the stability of the US financial system. (For more on the CFTC’s report, see this blog post.)

The Federal Reserve’s monitoring framework distinguishes between sudden changes to financial or economic conditions (shocks) and changes that tend to build up gradually and are understood to be “the aspects of the financial system that are most expected to cause widespread problems in times of stress” (vulnerabilities). The Report notes that vulnerabilities are often interrelated, evolving, and prone to be exacerbated by external shocks, which in turn can cause vulnerabilities to amplify such shocks. According to the Report, however, vulnerabilities are difficult to assess because of their shifting nature and the Federal Reserve’s inability to properly measure them with currently available research and data.

Regarding near-term risks to the financial system, the Report states that climate change “is likely to increase financial shocks and financial system vulnerabilities that could further amplify these shocks.” In the Federal Reserve’s view, as climate risks increase in frequency and intensity, these risks are likely to create new vulnerabilities — or exacerbate existing vulnerabilities — that could escalate into financial stability risks. The Report notes that “acute hazards, such as storms, floods, droughts, or wildfires, can quickly alter, or reveal new information about, future economic conditions or the value of real or financial assets. Moreover, in the presence of rapid shifts in public perceptions of risk, chronic hazards (like a slow rise in sea levels) have the potential to produce similar abrupt repricing events.”

The Report highlights several factors that could mitigate climate-related financial vulnerabilities or shocks, including:

  • Implementing increased transparency, measurement, and disclosure within the financial system, to improve climate risk pricing and reduce asset price volatility
  • Researching the interconnections between the climate, the economy, and the financial sector, to improve knowledge of linkages, exposures, and risk transmission channels
  • Mitigating or adapting to the physical effects of climate change through technological advances and policy changes, to reduce climate risks outside of the financial system

Because climate risk mitigation follows from the Federal Reserve’s “assigned legal mandates,” according to Chairman Powell, the Federal Reserve will likely take supervisory and regulatory action to mitigate climate risks if they threaten US financial system stability. Indeed, the Report makes clear that the Federal Reserve already expects banks to have adequate systems in place to appropriately “identify, measure, control, and monitor” all of their material risks — climate risks included.

Join the Club: Network for Greening the Financial System

In a separate but related development, on November 11, 2020, Federal Reserve Vice Chair for Supervision Randal Quarles announced that the Federal Reserve had requested membership as an observer to the Network for Greening the Financial System (NGFS), a group of 75 global central banks convened in 2017 for the purpose of understanding climate risk and advancing risk management and mitigation responses. All members of the NGFS pledge to uphold the principles of the Paris Agreement, adopted by 189 (of 197) sovereign nations to reduce greenhouse gas emissions and global warming. The US became the only nation to withdraw from the agreement (effective as of November 4, 2020), although President-elect Joseph R. Biden has vowed to notify the United Nations of the US’s intention to rejoin the accord on his “first day in office.”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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