Community banks need supervisors' help in assessing climate risk

• Key insight: Small banks are uniquely vulnerable to local climate disasters. Supervisors should be playing a more active role in helping them identify, measure and manage their risk.
• What's at stake: Climate-related risk drivers are growing and have several distinctive attributes: The impact is rising and far-reaching; the precise timing and impact are subject to deep uncertainty; and the future impact is likely to differ from the past.
• Supporting data: An unusually severe freeze in January in Florida caused billions in agriculture losses and a historic tornado outbreak in the Midwest destroyed businesses and homes, triggering emergency declarations, and underscoring the growing risks that extreme weather poses to communities, insurers, and banks.

For years, climate risk discussions in banking have focused on the largest institutions. Yet, the financial institutions most exposed to the impacts of extreme weather are not the ones with the largest and most diversified balance sheets. Small financial institutions, such as community banks, savings and loans, and credit unions, whose borrowers, collateral, and deposits are often concentrated in a single region, are especially vulnerable to the financial and economic impact from a wildfire, flood, drought, or severe storm.

Already through the first half of this year, we have seen several extreme weather events with localized impacts. An unusually severe freeze in January in Florida caused billions in agriculture losses and a historic tornado outbreak in the Midwest destroyed businesses and homes, triggering emergency declarations, and underscoring the growing risks that extreme weather poses to communities, insurers, and banks.

There is a strong argument for small banks to integrate these risk drivers into their existing risk management frameworks and for bank supervisors to encourage these efforts.

Small banks have long managed the risks posed by extreme weather events. For example, a hurricane might raise a bank's credit risk if default rates among borrowers rise. It may increase a bank's operational risk if its branch network or supply chain are disrupted by the storm. The effects of a storm could also ripple through the local economy or through insurance markets, bringing additional indirect impacts.

The challenge is that climate-related risk drivers are growing and have several distinctive attributes: The impact is rising and far-reaching; the precise timing and impact are subject to deep uncertainty; and the future impact is likely to differ from the past. Moreover, these risks may materialize through many channels at once and interact with other risk drivers to create compound effects.

For example, as the price and availability of insurance change in response to rising physical risks, financial losses get reallocated among borrowers, insurers, and creditors in ways that are difficult to predict and hard to price.

Fortunately, bank supervisors already have the responsibility to consider these growing risk drivers. Because their core mandate is to promote the safety and soundness of the banks they supervise, assessing climate-related risk drivers fall squarely within that remit and there is no need to change the scope of supervision. There are three key ways they can do this.

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First, it's important that bank supervisors use forward-looking assessments of a bank's physical risks rather than relying solely on historical data and relationships. Past weather patterns and outcomes are becoming a less reliable guide to future risks. A supervisor looking only at a bank's loss history may miss risks that are growing quickly in a changing climate. Forward-looking tools such as scenario analysis or stress tests can help to close that gap. Supervisors can also highlight emerging risks to help banks prioritize their risk management efforts. For example, Washington State issued guidance on wildfire risk last year.

Second, as part of routine engagement, supervisors can ask small banks how governance structures, risk-management frameworks, business continuity plans, borrower assessments, and strategic planning processes account for the potential financial impacts of extreme weather events and the related risks. Where material risk concentrations are identified in these conversations, examiners can ask banks to demonstrate how the underlying risk drivers are incorporated into traditional risk management processes such as credit underwriting, concentration limits, and stress testing to assess the materiality of the risk.

Third, supervisors can help identify or provide small banks with tools they can use to actively identify, measure, and manage their material risks. This can include highlighting publicly available data sources, sharing examples of sound risk-management practices, and encouraging proportionate approaches based on each institution's size, business model, and risk profile. New York State's proportionate risk management guides for banks on climate-related risks is one example of how to do this.

None of these steps require new regulatory authority or change the goals of supervisors. They simply help supervisors ensure that existing risk management practices remain fit-for-purpose as the underlying risk environment evolves and new risk drivers emerge.

Small financial institutions are central to American economic vitality because they finance local businesses, farms, commercial real estate and households. Supervisors can play an important role by helping them understand evolving risks, strengthen resilience and continue to serve the communities that depend on them.