By Meg Sczyrba, CRCMNatural disasters are becoming more commonplace, thanks to climate change. While events such as floods, wildfires, droughts and ocean acidification might feel far removed from our world of bank compliance, their impact is already forcing subtle shifts in our daily work. As climate change intensifies, its effect on our jobs will continue to grow.
Climate change hasn’t gone unnoticed. President Biden recently signed the Climate-Related Financial Risk Executive Order. It encourages bank regulators to assess climate risk and asks Treasury Secretary Janet Yellen to issue a report quickly on how bank supervision will incorporate climate-related financial risk. Yellen had previously called climate change the biggest emerging threat to the health of the U.S. financial system
The Basel Committee on Banking Supervision has also considered climate risk and published several white papers on the subject at bis.org. This international group of regulators quantify the risk for the financial services industry as twofold:
- Physical risk. The risk of financial loss resulting from the increasing severity and frequency of extreme climate change-related weather events such as heatwaves, landslides, floods, wildfires and storms as well as indirect effects of climate change.
- Transition risk. The risk related to the process of adjustment towards a low-carbon economy, including funding commercial loans.
Regulators have primarily been focused on credit risk but will undoubtedly turn more attention to regulatory risk. To prepare compliance officers for that eventuality, this article considers how the physical risks of climate change are impacting the rules we work with daily.
Climate change basics
Climate change is a very large issue, but compliance officers are adept at issue management. After learning of a concern, the first step is to perform a root cause analysis, or in this case, to understand climate change basics.
According to the National Aeronautics and Space Administration, burning fossil fuels like coal and oil releases carbon dioxide into the atmosphere. This change traps more heat which causes the Earth’s average surface temperature to rise. In more concrete terms, the United Nation’s World Meteorological Organization found the Earth’s average surface temperature is now consistently one degree Celsius warmer than it was in 1900. While one degree might not sound like much, every degree of change has a considerable impact on long-term weather patterns. And, the temperature is rapidly approaching the 1.5 degrees Celsius (2.7 degrees Fahrenheit) benchmark at which climate change creates significantly more problems and potentially becomes irreversible. The agency warns there is a 44 percent chance the Earth will reach this pivotal point within the next five years. (Because of the additional carbon in the atmosphere this year, the agency’s projection is double last year’s projection of 22 percent).
Climate change impacts include rising sea levels, extreme storms, heat waves and droughts. These events can modify the physical environment to pave the way for more pandemics. In addition, the carbon dioxide causing the rise in temperatures is also turning oceans more acidic, which can affect the entire food web. While all these events are occurring globally, geographic regions will be impacted differently. NASA explains that some U.S. regions have seen increased rainfall while others have experienced decreased precipitation. Those trends are expected to continue, with future climate changes coming more rapidly than in the past. Climate change predictions are also dependent on levels of future emissions of carbon dioxide.
Rising sea level and extreme storms
As the planet heats up, increased surface temperatures impact the ocean in two basic ways: water expands as it warms, and ice sheets and glaciers melt more rapidly. Both contribute to the rising sea levels. Morgan McFall-Johnson, a science editor at Business Insider, estimates that the sea will rise three and a half to seven inches by 2030—twice as fast as the prior 20 years. In addition, the National Oceanic and Atmospheric Administration cautions that the rising sea level increases the risk of high tides and puts coastal communities at great risk for erosion and storm surges. This change would impact 53 percent of the U.S. population according to a study conducted by Arenas Lam, et al., in 2009.
Because the warmer atmosphere can hold more moisture, storms will bring heavier and more frequent rainfall. According to the 2021 BCBS white paper “Climate-Related Risk Drivers and Their Transmission Channels,” storms will cause flash flooding and landslides that will damage property and infrastructure. Along the coast, the extra warmth and water means hurricanes will be slower, stronger and grow more quickly and intensely. McFall-Johnsen also estimates that by the close of the decade, the Northeast coast will experience a fivefold increase in annual floods
The BCBS addressed the expected financial impacts of these extreme storms. Aside from the immediate damage to homes, the global group of regulators predict insurance rates will double in the near-term future. Increased costs could render insurance unaffordable to some homeowners or, if the costs to insurers are too high, it could potentially be unavailable in some areas. This includes flood insurance, which is the subject of regular debate and frequent short-term extensions within the U.S. Congress.
Renee Cho, author and researcher for Columbia University’s State of the Planet, relays that insurance rates had already increased 50 percent between 2005 to 2015. In her December 2019 article, she also predicts that local taxes will rise as communities take actions to prevent future flooding. These actions could include for example, building a comprehensive grid of levees and dams.
Heat waves and droughts
Extreme storms aren’t the only climate change impact. NASA predicts summer temperatures will keep rising, especially in the western and central United States. These extended periods of increased heat will be especially impactful to agriculture. NASA also predicts that extreme weather will lead to crop losses despite an increased growing season. BCBS reinforced concerns about the financial impacts to farming. In addition to limiting agriculture output, warmer temperatures dry out plants and trees, which then ignite more easily and can lead to more frequent and bigger wildfires. McFall-Johnsen estimated that forests are burning at twice the rate they did in 1984. Conditions in California are even more severe—the annual area burned in summer wildfires increased fivefold between 1972 and 2018. In dollar figures, the 2020 wildfire season on the west coast cost insurers between $7 to $13 billion.
Warmer temperatures could also impact jobs. Cho predicts the sequential heat waves will make working outdoors so unbearable that laborers may shift away from outdoor work like agriculture and construction. This change will disproportionately impact members of minority groups, particularly the Hispanic or Latino community, according to Department of Labor and Bureau of Labor Statistics reports. This is especially true in agriculture where 83 percent of farmworkers identified as Hispanic.
Higher temperatures also lead people to use more energy to cool their living spaces. Cho noted that 93 percent of U.S. cities have already seen increased days requiring extra cooling. She predicts utilities will raise electric rates while the likelihood of blackouts will also increase. In addition, local taxes could also rise as municipalities seek to repair damage to infrastructure caused by the higher temperatures. For example, roads will need to be repaved more frequently.
Ocean acidification and pandemics
According to NOAA, the ocean absorbs about 30 percent of the carbon dioxide in the environment (). As the levels increase in the atmosphere, seawater also takes on higher amounts, triggering a chemical reaction that results in more acidic oceans. McFall-Johnsen predicts the resulting mass migration of marine life will directly impact those who earn a living on the seas.
On land, climate change reshapes the environment, driving species to migrate to new, more suitable habitats. This includes animals, plants and even viruses and bacteria. These shifts could place them in closer proximity to humans, which was one underlying cause of the COVID-19 pandemic. Robert Preidt, of WebMD explains that warming temperatures modified the Chinese terrain to become more hospitable to bats, which are known to carry coronaviruses. In fact, Preidt states, “an additional 40 bat species that harbor 100 more types of bat-borne coronavirus have moved into Yunnan province [where COVID-19 originated]in the past century, according to the study published Feb. 5 in the journal Science of the Total Environment.”
Compliance implications of climate change
After pursuing the root cause, compliance officers need to consider compliance implications of the issue they are investigating, by applying their knowledge of the regulatory environment. In the case of climate change, the resulting rising sea levels, extreme storms, heat waves, droughts and pandemics will each impact compliance. Consider the following:
Appraisals. Real estate appraisal regulations require banks to obtain a formal property valuation prior to securing a real estate loan. BCBS notes that severe weather events cause property values to decline so banks will want to ensure their appraisers adequately factor climate vulnerability into their valuation. While there is evidence that immediate impacts may already be factored into the price of the real estate by savvy buyers, future impacts will be more difficult to discern. For safety and soundness reasons, though, banks will want appraisers to account for longer term impacts due to the length of time mortgages remain on the books. Banks will need to ensure any climate change valuation considerations are addressed uniformly.
Community Reinvestment Act. CRA requires banks to report their consumer and business lending annually. Regulators then evaluate the bank based on its lending to low- and moderate-income areas in each category. Climate change presents both impacts and opportunities in this area of compliance.
The Federal Reserve Bank of San Francisco’s “Climate Adaptation Investment and the Community Reinvestment Act” white paper acknowledges that low-to-moderate-income communities are highly vulnerable to climate change impacts because they have fewer resources available to weather the storms. The regulator noted that a high percentage of counties impacted by past climate change-related disasters had CRA-eligible tracts. Banks may want to have a plan in place for how to continue meeting LMI lending goals as climate change impacts accelerate.
Taking it a step further, the white paper goes on to encourage banks to support community investments to reduce climate change vulnerabilities. Regulators will positively consider all activities that either prevent disaster or revitalize a disaster area, particularly in LMI neighborhoods.
Another CRA opportunity arises as laborers choose to avoid the heat, shifting away from outdoor jobs. Banks can support economic development through workforce training programs in communities feeling the economic impacts of climate change. Because smaller farming operations are less likely to be able to absorb the added expenses climate change will bring, banks may find it increasingly difficult to make prime loans in this sector. Unless the rule is amended, banks may have to choose between CRA ratings and losing money on more questionable loans.
Fair lending. There are several ways that climate change will need to be addressed within fair lending compliance:
- Biden’s executive order expresses concern for climate change’s disparate impact on minority communities. There are several underlying causes for increased vulnerability. Like LMI communities, this population tends to have less savings available for added expenses. The predicted job shift away from outdoor work could exacerbate this situation.
- In addition, BCBS found that banks are inclined to reduce lending to climate exposed areas. As banks modify underwriting practices to account for climate change, they will want to consider the impact on minority lending. And if banks place underwriting restrictions on affected geographic areas, banks will want to consult mapping that identifies minority census tracts. If there is significant crossover, banks will want to document their business justification for their actions.
- BCBS notes that climate change will have a negative impact on the ability of some borrowers to repay. Homes may require expensive repairs while rising insurance, taxes and utility bills add up to make homeownership more expensive. To avoid allegations of predatory lending, banks will need to ensure they are not putting borrowers into a loan they cannot afford in either the short or long term. In addition, banks will need to find a way to uniformly underwrite mortgage loans to account for these added expenses.
Flood insurance. With high water events on the rise, mortgages may wind up underwater—both literally and figuratively. Flood insurance rules can protect both banks and homeowners—and both will want the assistance. To safeguard all interests, banks should pay particular attention to the following aspects of the regulation:
- Banks must verify whether a borrower’s community is participating in the National Flood Insurance Program at the time a loan is made, modified, or renewed. It will be critical to stay up-to-date on community status, as this could change rapidly depending on how quickly communities respond to the increased risk.
- Special Flood Hazard Area maps may also evolve quickly. The Federal Reserve Board of San Francisco Bank published a Community Development Innovation Review focused on Strategies to Address Climate Change Risk in Low- and Moderate-Income Communities (2019). The Review finds that our current mapping is out-of-date and does not adequately capture flood risk. Climate change will exacerbate this mapping inadequacy. At a minimum, banks will want to ensure their flood vendor maintains up-to-date software. They may also consider exploring new ways to better evaluate flood risk.
- Banks must ensure that flood insurance is maintained throughout the life of the loan. With flood insurance rates expected to continue rising to the point of being unaffordable, banks will want to determine in advance, how to handle borrowers who can no longer afford required flood insurance.
RESPA. Compliance officers are all too aware of the strain the pandemic put on compliance and are likely still dealing with some of the fallout. Perhaps the most significant implication was to RESPA, which regulates how banks work with customers in arrears. If the added expenses of home repairs, insurance, taxes and utilities are significant, there could be a new surge in existing homeowners going into loan modification or foreclosure. (For more information, see “The Long Shadow: COVID-19 Continues to Pose Significant Compliance Challenges for Mortgage Servicers.”)
Risk-assessing climate change
Once compliance officers have determined the full extent of an issue, they consider the level of risk involved. In this case, they will want to consider the impacts climate change will have on existing risk assessments in whatever manner that is done within their bank. If regulations are assessed separately, then each of the above rules should be considered for increased inherent risk with the risk trend increasing. Other areas of the bank such as operational risk and credit risk may also want to acknowledge these shifts while the bank itself may want to conduct a stand-alone climate risk assessment.
Overall, climate change is clearly risky business. We are already experiencing its impacts in the form of rising sea levels, extreme storms, heat waves, droughts, ocean acidification and pandemics. The impacts to our physical environment and consequently the financial system in which we work are predicted to worsen rapidly. While we can collectively work towards curbing underlying causes, understanding climate change and the risks it poses prepares us as compliance officers to help our banks navigate this emerging and unprecedented risk.
Meg Sczyrba, CRCM, has been involved in the compliance industry for over 25 years and currently chairs the editorial advisory board of ABA Bank Compliance magazine. She formerly chaired the ABA Compliance School and CRCM advisory boards and participated as a member of the ABA Compliance Executive Committee.