Learn from US failings to maintain confidence in smaller banks

Regulators should supervise all banks on all risks

In the aftermath of Silicon Valley Bank’s collapse, small and mid-sized banks across the US are increasingly viewed as riskier than large banks. Regulators are a key cause of this perception. Large banks are perceived as ‘too big to fail’ and, since their failures could cause widespread financial instability, they are subject to more stringent regulation. Some regulations, including critical guidance from federal bank regulators on managing climate risk, only apply to banks with more than $100bn in assets. This needs to change.

To restore consumer confidence in small and mid-sized banks, regulators need to supervise and regulate them on all types of risk, including climate change. Small and mid-sized bank portfolios are naturally more concentrated than large bank portfolios, which can increase small banks’ exposure to climate-related risks.

A report by the National Credit Union Administration and Ceres’ credit union report both found significant exposure to physical climate risk among credit unions. Rising sea levels and more extreme storms have already led to the closure of two Louisiana credit unions following Hurricane Katrina in 2005.

Likewise, small banks in communities where local economies are concentrated in the fossil fuel sector face increased risk stemming from the transition to a clean energy economy. A World Bank paper found that climate-related regulation on large banks in Brazil caused a shift in lending to high-emitting sectors from large to small banks, further increasing risks.

Michael Barr, the Federal Reserve’s vice chair for supervision, summed it up during a Senate Banking Committee hearing in March: ‘While the Federal Reserve’s framework focuses on size thresholds, size is not always a good proxy for risk.’

As trust in US banks wavers, Ceres urges the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation to regulate the full scope of risks faced by small banks. Each agency has issued draft climate risk management guidance for banks with over $100bn in assets. If issued jointly and applied to all supervised institutions, the agencies could help restore confidence in bank risk management.

While it is true that small and mid-sized banks are often impacted more by regulatory compliance costs than large banks, joint inter-agency guidance could help reduce that burden. Aligning with the New York State Department of Financial Services’ proposed guidance for managing climate risk, which will apply to the more than 1,200 banking entities it regulates, would be even better.

The NYDFS guidance takes a practical approach. It recognises that regulated organisations ‘do not all have the same level of resources to manage these risks’ and says they ‘should take a proportionate approach to the management of the climate-related financial risks they face, appropriate to each organisation’s exposure to climate-related financial risks’. NYDFS does not expect small banks to use the same level of sophisticated climate-related quantitative modelling that large banks are implementing. Still, there are climate-related risk management strategies that small banks can and should take.

The Fed is now beginning climate-related scenario analysis with only the six largest US banks. Barr wrote in the Fed’s report on SVB that ‘Supervisors should be encouraged to evaluate risks with rigour and consider a range of potential shocks and vulnerabilities, so that they think through the implications of tail events with severe consequences.’

SVB has shown that a wider range of banks need to be subject to more stringent oversight. Climate scenario analysis must be applied to all banks and the Fed’s methodology should be expanded to capture risks more completely. This includes indirect impacts, like contagion channels and supply chain disruptions, which pose significantly more risk than the direct impacts according to Ceres’ transition risk report and Mizuho’s analysis. Finally, regulators should incorporate climate into their bank rating system, known as ‘CAMELS’ in the US.

In the Fed’s report, Barr noted ‘In the case of SVB, supervisors delayed action to gather more evidence even as weaknesses were clear and growing.’ If banking regulators are to maintain confidence in small and mid-sized banks, they must not delay and instead get serious about supervising all risks, including climate risk.

Amy Kvien is Manager, Financial Institutions, Ceres Accelerator for Sustainable Capital Markets.

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