Climate Change and Community Banks: A Risky Intersection
As we look ahead to next year, the Office of the Comptroller of the Currency (OCC) is planning to decrease supervision of community banks. While this decision seems to be based on the conventional wisdom that smaller, less complex banks need less oversight, this could be a potentially dangerous move, considering the increasing effects of climate change on the financial system. For community banks, which are often geographically constrained and operate in areas vulnerable to climate change, this decision could expose them to risks that larger, more complex, and diversified banks may not face. It’s crucial that regulators remain responsive to these risks, regardless of the size of the institution.
The Growing Impact of Climate Change on the Financial System
Climate change is creating an increasing number of challenges for banks and other financial institutions. Severe and frequent climate disasters are forcing property insurers to pull out of vulnerable areas, which could lead to significant losses for mortgage lenders when these disasters strike. Banks that lend to sectors susceptible to climate change are also exposed to physical and transition risks through their loan portfolios.
Earlier this year, Federal Reserve Chair Jerome Powell warned that, given the current trajectory of climate change, there could be regions in the U.S. where it will be impossible to get a mortgage or access banking services in the next 10 to 15 years.
Regulatory Measures and Climate Change
Under the Biden administration, bank regulators have started to take note of these climate-related risks. In 2023, the Federal Reserve, Federal Deposit Insurance Corporation, and OCC issued Principles for Climate-Related Financial Risk Management, a framework for managing climate-related financial risks. The following year, the Federal Reserve published the results of its Pilot Climate Scenario Analysis Exercise, an initiative to understand bank exposures to climate risks and their ability to manage them.
Unfortunately, these measures were rolled back by the Trump administration. They were crucial first steps, but they had their limitations. Primarily, they only considered the risks faced by large banks, overlooking the risks faced by smaller institutions and the broader financial system.
Risks Faced by Community Banks
Community banks, though smaller and less central to the stability of the financial system, face unique climate risks due to their limited scope. Unlike larger banks, community banks often operate within a fixed geographical area, making it difficult for them to diversify away from climate risks. They also lack the ability to offload commercial loans made to climate-risky companies onto investors, a channel that is widely available to larger banks.
Community banks play a pivotal role in agricultural lending, a sector highly exposed to the physical risks of climate change. Changes in temperature and precipitation patterns can cause significant financial risks for these lenders as they can drastically affect crop yields and the geographic landscape of agricultural production. As of 2023, the FDIC estimated that 69% of loans to the agricultural sector in the U.S. were held by community banks.
The Need for a Comprehensive Approach
While the decision to roll back supervision might be seen as a victory by the community bank lobby, it could be a short-term solution to a long-term problem. If Chair Powell’s predictions come true, community banks serving regions affected by climate change could cease to exist or be forced to shrink as climate change continues to impact these areas.
Ensuring the long-term viability of community banks requires more than just deregulation. Supervisors need to work with these banks to manage their exposure to climate risks and promote continued access to financial services, including in climate-vulnerable geographies.
It’s also important to address the risks that larger banks pose to the rest of the financial system. Regulators need to assess climate risk on a system-wide basis, rather than just on an institution-by-institution basis. After the global financial crisis, regulators put guardrails on risky lending that banks originated but distributed to other financial system players. Similar measures should be put in place to manage climate-risky activities to prevent larger banks from profiting at the expense of smaller entities or the public.
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