Financial Institutions Need to Prepare for Climate Risk

Recently, two Federal Reserve officials spoke on the impact of climate-related risks to financial institutions.

Kevin Stiroh, Executive Vice President at the Federal Reserve Bank of New York, noted that there were two climate-related risks confronting financial institutions -- physical risk and transition risk.

Stiroh stated: "Physical risk is the potential for losses as climate-related changes disrupt business operations, destroy capital and interrupt economic activity. Transition risk is the potential for losses resulting from a shift toward a lower-carbon economy as policy, consumer sentiment and technological innovations impact the value of certain assets and liabilities."

In a speech at a San Francisco Federal Reserve Bank conference, Federal Reserve Governor Lael Brainard noted that severe weather events could impact clearing and settlement activities and increase the demand for cash.

Brainard cautioned that financial institutions need to "manage risks surrounding potential loan losses resulting from business interruptions and bankruptcies associated with natural disasters, including risks associated with loans to properties that are likely to become uninsurable or activities that are highly exposed to climate risks."

She stated: "For example, if prices of properties do not accurately reflect climate-related risks, a sudden correction could result in losses to financial institutions, which could in turn reduce lending in the economy."

Brainard commented that this decline in asset prices could result in a negative wealth effect, which could affect economic activity.

Brainard also noted that low-income communities are particularly vulnerable to climate-related disasters, as these communities have less liquid savings to meet emergencies arising from the loss of income and property.

Both officials stated that the Federal Reserve expects financial institutions to have risk management systems that appropriately identify, measure, monitor, and manage climate risks and build resiliency into their business models.

Read Stiroh's speech.

Read Lael Brainard's speech.