Comments to the Financial Stability and Oversight Council
This is my public comment supporting Public Citizen's campaign on climate and financial stability
Background*
In 2010, Congress determined that, to prevent another financial crisis, insurance companies and other non-bank financial institutions that could threaten financial stability—either through their own material distress or through their activities—need enhanced federal supervision. The Dodd-Frank Act authorized the Financial Stability Oversight Council (FSOC) to identify firms that are systemically important and to designate such firms for supervision and regulation by the Federal Reserve.
Guidance adopted by FSOC in 2019 to implement these provisions of the Dodd-Frank Act established a series of barriers to designating entities that are, in fact, systemically important and ought to be supervised by the Federal Reserve. These barriers have made designations virtually impossible, frustrating Congress’ intent that FSOC can use these designations as a precautionary measure to avoid financial crashes and public bailouts of financial institutions. For example, the 2019 guidance called for FSOC to perform costly, time-consuming and unnecessary analyses prior to designation, which effectively prohibited FSOC from designating systemically important institutions.
*The background section here is reproduced from the material created by the campaign of over 25 advocacy organizations.
Support for the framework
The FSOC’s revised interpretive guidelines and analytic framework take important and welcome steps towards addressing pressing threats to the financial system. The shift from an activities-based model and the clarifications regarding cost-benefit analysis and companies’ material financial distress are greatly appreciated. We do not believe that the 2019 guidance stipulating the need for cost-benefit analyses and the need to consider a company’s material financial distress when designating NBFIs was in keeping with the spirit of the Dodd-Frank Act. This revised guidance will rectify these errors. The careful consideration of a broad range of risks to the financial system, vulnerabilities, and transmission channels in the proposed analytic framework is much appreciated.
Most importantly, we are pleased to see that the council is beginning to consider climate-related financial risk by explicitly mentioning this as an issue that the council will monitor. Pursuant to this, the acknowledgement that threats to financial stability could derive from external sources and long-term vulnerabilities and attention to the fact that activities that are sizable and interconnected with the financial system can destabilize markets even when these activities are intentional and permitted by law will be important to addressing climate-related financial risk.
Suggested improvements to the framework
Having said this, we urge the council to do more to incorporate climate-related financial risk into this framework. The council should consider incorporating climate-related financial risk into its definition of financial stability. A thorough understanding of climate-related financial risk will be imperative to the performance of the council’s statutory duties and to achieving the council’s statutory purposes.
Impact of climate-related financial risk on non-bank financial institutions
Climate-related financial risk exacerbates the already considerable threat to financial stability posed by non-bank financial institutions. Studies show that non-bank financial institutions have greater exposure to climate-related financial risks than other financial institutions. More concerningly, we lack an understanding of the contagion potential within the financial system that this poses. Insuring and financing fossil-fuel ‘sunset’ industries creates systemic risk by exposing the financial system to $1.4 trillion in stranded assets. Moreover, the United States has the largest share of stranded assets globally. Physical climate risks also get transferred through non-bank financial institutions onto municipal, state, and federal balance sheets. For example, insurers are withdrawing coverage from California and other climate-vulnerable regions. Loss of coverage would simultaneously decrease revenues and increase demand for public spending.
Summary of recommendations
Climate-risk poses serious threats to financial stability. It is imperative that the FSOC incorporates climate risk into its definition of financial stability. The revised interpretive guidelines and proposed analytic framework have taken an important step towards this goal. However, they could be improved by incorporating climate-risk in more specific and concrete ways. These may include understanding the two different types of climate risk: physical risk and transition risk. Including transition risk in the description of vulnerabilities that are considered in the framework. Making climate-risk a criterion for NBFC and SIFI designations. Supporting the resilience of futures markets against climate risk. And filling gaps in our data and knowledge regarding the systemic threats to financial stability posed by climate risk.
List of specific recommendations
1) Definitions of financial stability should incorporate climate risk.
Climate risks include both physical risks and transition risks. Climate disruption will increase the frequency and severity of natural disasters which will have financial consequences for non-bank financial institutions. Insurers will need to assess the risks of insuring climate-vulnerable regions. Natural disaster supply-chain disruptions impact agricultural and commodities markets and pose risks to futures markets.
Transition risks pose a systemic threat to non-bank financial institutions. These institutions are disproportionately invested in fossil fuels assets vulnerable to becoming stranded. Concurrent transition and physical risks could compound, leading to even more severe financial risks. Climate-related risks could interact with existing, non-climate-related vulnerabilities in the financial system.
2) Include climate vulnerabilities in the analytic framework.
The description of vulnerabilities that the proposed analytical framework currently includes is well-considered. However, the framework should also incorporate vulnerabilities arising from climate risk. This could either be added as an additional vulnerability or incorporated into the description of interconnections by including loss amplification to this description. To elaborate: transition risks pose the risk of loss amplification from stranded assets. Vulnerabilities from stranded fossil fuel assets not only reflect in the market valuations of oil and gas companies but will also be amplified and reflected in the valuations of asset managers that have investments in these industries. Studies estimate that loss amplification from investments in fossil fuels could amount to $681 billion. Pension funds in the U.S. own the lion’s share of this risk. Therefore, it is imperative to include loss amplification arising from transition risk as a mechanism of vulnerability in the financial system.
3) NBFC determinations and SIFI classifications should take climate-risk into consideration.
The analytic framework specifies certain conditions under which the FSOC can invoke Section 113 of the Dodd-Frank Act to evaluate nonbank financial companies for entity-specific determinations. These conditions should be expanded to include climate-related exposures. Furthermore, all financial institutions which are vulnerable to shocks arising from both physical and transition risks should receive systemically important financial institution designation. There are currently a number of financial institutions, including Fannie Mae and Freddie Mac, which face systemic risks arising from climate change.
4) Include the impact of climate risk on futures markets.
The proposed analytic framework should include the financial risks posed to futures markets by the physical risks arising from climate change. It can do so by recommending that the Commodity Futures Trading Commission and/or the Securities and Exchange Commission consider the impact of climate risk on commodities markets when prescribing risk-management standards for Financial Market Utilities such as derivatives clearing organizations registered under section 5b of the Commodity Exchange Act or clearing agencies registered under section 17A of the Securities Act of 1934.28.
In addition, below are further steps the Council could take to ensure all of its authorities for addressing potential risks to U.S. financial stability are appropriately exercised:
5) Commission studies of the threats posed by climate risks to financial stability.
Pursuant to taking cognizance of physical and transition risks in definitions of financial stability, it is imperative that we understand the nature and extent of risk these will pose for the financial system. Existing data and studies on this topic are limited in this regard. Specifically, while we have studies that examine exposures in the banking sector to climate transition risk, we do not have equivalent studies for the non-bank sector. We also lack data on the risks faced by private insurers in climate-vulnerable regions and the securitization of lending to these regions. We, there, propose three studies:
Study A should assess U.S. non-bank financial institutions’ exposure to climate transition risks. This should include risks arising from investment in the fossil-fuel industry and the potential for exposure to stranded assets.
Study B should assess the securitization of lending to climate-vulnerable regions and the implications this should have for designating systemically-important financial institutions.
Study C should assess the risks posed by climate-related natural disasters to insurers and provide recommendations for making the insurance system resilient to climate-related natural disasters. This study would investigate reports of insurers withdrawing coverage from climate-vulnerable areas. Finally, it would assess the viability of creating a domestic equivalent of the loss and damage fund which is specifically designed to insure climate risk with rapid-response windows for disaster-related financing.
6) Support decarbonization of non-bank financial institutions and systemically important financial institutions.
Given the considerable financial risks that arise from exposure to stranded-assets in the ‘sunset’ fossil fuel industry, the Financial Stability Oversight Council should support decarbonizing the financial system. In a rapidly changing economy that is making a green transition, decarbonization will have to be one of the pillars of financial stability. This could follow leading asset managers by recommending that U.S NBFIs and SIFIs join the Glasgow Financial Alliance for Net Zero. The FSOC should also institute reviews of NBFIs and SIFIs to assess progress towards decarbonization of the financial system and mandate emissions disclosures to the Task Force on Climate-Related Financial Disclosures from these financial institutions.
7) Advise the Federal Reserve on climate risk.
The council should consider advising the federal reserve to:
Introduce ceilings on credit extension to fossil-fuel sunset industries which pose serious risks to non-bank financial institutions
Institute green differentiated reserve requirements: Decreasing reserve requirements on green assets would enable resource allocation to climate-resilient infrastructure