Clifford Chance

DFS expects Regulated Organizations to incorporate climate-related financial risk considerations into existing governance frameworks, risk management processes, and business strategies, and identifies key tools for inclusion in organizations' climate-related risk management arsenal.

At the end of 2022, the New York State Department of Financial Services ("DFS") released Proposed Guidance for New York State regulated banking and mortgage organizations ("Regulated Organizations") relating to the management of material climate-related financial risks.

DFS's Stated Interest in Climate-Related Risks

Climate change poses a wide range of risks to financial institutions. In an effort to foster the safety and soundness of supervised institutions and the operational resilience of New York State's financial system, DFS has stated that it is committed to ensuring that Regulated Organizations appropriately account for climate-related risks.

On October 29, 2020, DFS published an Industry Letter setting out its expectations that all regulated institutions begin to integrate climate-related financial risks into their business planning and start to develop an approach to related disclosures.

On December 21, 2022, DFS issued Proposed Guidance to provide further information regarding its expectations and assist Regulated Organizations in responding to evolving climate-related risks to their operational resiliency. DFS hosted a webinar on January 11, 2023 to provide additional details.

The Proposed Guidance's Approach to Climate-Related Financial Risks

DFS acknowledges that climate change affects Regulated Organizations in different ways and to varying degrees depending on size, geographic distribution, business lines, and other differentiating factors. In light of this, the Proposed Guidance directs organizations to take a proportionate approach to developing risk management strategies. This "proportionate approach" should allow Regulated Organizations to consider their unique exposure and available financial resources when developing a climate-related risk assessment framework. Smaller organizations that are part of a holding/parent company structure may leverage the policies and processes developed at the Group level in certain instances.

In an effort to align the Proposed Guidance with efforts by federal and international banking regulators to manage climate-related financial risk, DFS drew from climate-related guidance issued by other regulatory authorities, including the OCC, FDIC, FRB and the Basel Committee on Banking Supervision.

DFS encourages Regulated Organizations to look at expectations from other regulators when evaluating their risk management plans. For example, foreign banking organizations ("FBOs") are permitted to take into account home-country regulators' requirements when assessing whether certain climate-related financial risks are material or not. However, U.S. managers must still assess the adequacy of the FBO's policies and procedures, information systems, and oversight function for the New York licensed branch or agency through a U.S. lens, and U.S. supervisors must ensure that the FBO's head office is kept apprised of U.S. regulatory expectations that will impact on U.S. operations. Notably, in this context, DFS appears focused on the FBO's U.S. operations and not on the FBO's foreign or global operations.

Types of Risks To Be Considered

DFS states that it expects Regulated Organizations to develop a framework by which to assess and respond to climate-related risks. This framework should address the following five components of prudent risk management: 1) corporate governance; 2) internal control framework; 3) risk management process; 4) data aggregation and reporting; and 5) scenario analysis.

Under the Proposed Guidance, Regulated Organizations must consider two primary channels of climate-related risks when developing or revising their assessment and response frameworks: 1) physical risks; and 2) transition risks.

Physical risks – such as coastal erosion, droughts, hurricanes, floods, and heat waves – may have economic consequences for financial institutions, including:

• Destruction of capital and associated repair costs
• Business continuity challenges
• Increased operating costs
• Increased mortgage delinquency rates
• Increased insurance premiums or loss of coverage

Transition risks arise from economic and behavioral shifts. Such shifts are typically driven by policy and regulations, adoption of new technology, consumer and investor preferences, and changing liability risks. Transition risks can be widespread and may have both direct and indirect impacts on Regulated Organizations.

Data Gaps and Developments

Quantifying climate-related financial risks remains a challenge, particularly given that relevant data may not yet be captured by financial institutions' existing IT infrastructure. But "DFS urges organizations not to let uncertainty and data gaps justify inaction." Rather, the Proposed Guidance underscores the importance of continuing education in the climate change space. According to DFS, management and boards of directors are responsible for their organizations' operational resilience and safety and soundness. They should remain up to date on evolving climate change threats, and institutions should invest in management information systems that can help decision-makers assess these risks in a timely manner.

The Proposed Guidance identifies tools Regulated Organizations may use when evaluating climate-related financial risks, including:

• Data aggregation and reporting systems that can provide timely updates to identify and monitor new threats; and
• Climate scenario analyses to examine the resilience of business models in the short, medium and long term, identify areas of exposure, and measure an organization's vulnerability to relevant risk factors. This is different than traditional stress testing, which seeks to assess the potential impact of transitory shocks to near-term economic and financial conditions.

Fair Lending to All Communities

The Proposed Guidance emphasizes that, in managing climate-related financial risks, Regulated Organizations may not implement risk mitigation strategies that adversely impact low- and moderate-income ("LMI") communities and communities of color. Rather, DFS expects that Regulated Organizations will minimize and affirmatively mitigate adverse impacts on LMI communities and communities of color, which are disproportionately impacted by climate change and natural disasters. The Proposed Guidance warns that Regulated Organizations should not seek to disinvest from these communities as a means of climate-related risk management. Instead, institutions must continue to ensure fair access to capital and credit.

Looking Ahead

DFS has requested feedback on the Proposed Guidance by March 21, 2023. As of now, the Proposed Guidance does not require Regulated Organizations to disclose material financial risks relating to climate change, but this may change as common metrics for financial risks are established at the federal and international level. These metrics will likely be tied to real-world climate targets.

Additionally, the Proposed Guidance does not establish a timeline for implementation. DFS is seeking input as to whether such timeline should be established and if so, what that timeline should look like.

The Proposed Guidance emphasizes the need for Regulated Organizations to stay up to date with climate-related developments. To that end, institutions should continue to invest in their information systems and education programs to ensure decision-makers are well positioned to make informed assessments.