Tuesday, August 29, 2023

Commissioner Romero proposes urgent review of financial institutions’ climate-related risks

By Suzanne Cosgrove

Speaking at a Yale University conference on sustainable finance and investment on Friday, CFTC Commissioner Christy Goldsmith Romero stressed the importance of regulated commodity and financial derivatives as risk management tools in the event of weather disruptions, and also addressed the topic of exchanges’ material exposures to climate-related financial risks.

“The markets the CFTC regulates are directly impacted by extreme heat, drought, wildfire, floods, and storms, all of which have been made more intense and frequent by climate change,” Romero said.

“To use the lessons from the past to have a climate-resilient future, as regulators, we need to appreciate the size and scope of the risk that climate change poses to our financial system and markets. … We need to ensure that there is appropriate climate risk management so there is not a threat to financial stability,” she added.

Previous warnings. Romero pointed to a prior CFTC report from the climate-related market risk subcommittee of the Commission’s Market Risk Advisory Committee (MRAC) released in 2020, “Managing Climate Risk in the U.S. Financial System,” as an early warning of potential market stress.

Although the report stated climate change “poses a major risk to the stability of the U.S. financial system,” there was not much response to the MRAC’s recommendations for more targeted oversight.

The MRAC’s 196-page report cautioned: “Both physical and transition risks could give rise to systemic and sub-systemic financial shocks, potentially causing unprecedented disruption in the proper functioning of financial markets and institutions.” The report stated that shocks to particular sectors or regions “could reduce access to financial services by marginalized communities and people already underserved by the financial system.”

A year later, in 2021, the Financial Stability Oversight Council (FSOC) issued its recommendations to address the challenges posed by climate-related financial risks. The FSOC’s report highlighted electric utilities, oil, motor vehicle production, and transportation as sectors most likely to be affected, but it also included a look at banking institutions’ and insurers’ exposures to related credit and market risks.

Starting a new chapter. In her speech on Friday, Romero forged ahead, delivering three proposals that she said would help the CFTC implement FSOC’s 2021 recommendations. “The CFTC is a market regulator like the SEC,” she told the group. “Only instead of stocks and bonds, we regulate derivatives of commodities like wheat, oil, and copper, as well as (derivatives) of interest rates and other financial products. The risk management functions of these markets are integral to the global response to climate change.”

In proposal No. 1, Romero stated, “The Commission should conduct a horizontal supervisory review of climate risk management at exchanges, clearinghouses and, in conjunction with the National Futures Association, at market intermediaries.”

The CFTC’s supervisory review of climate-risk management by exchanges and clearinghouses should be done “without delay,” Romero said, but she acknowledged that responses to the CFTC’s climate risk RFIs have confirmed that clearinghouses and exchanges “are already including climate-related risks as part of their risk management frameworks.”

Romero’s proposal No. 2 would mandate the CFTC to “work with its largest regulated entities, particularly those deemed systemically significant, on scenario analyses to increase our understanding of climate impacts in derivatives markets.”

Again, she noted that “the Commission does not need to start from scratch.” Exchanges and clearinghouses have begun conducting internal stress tests using climate-related scenarios, Romero said. “Clearinghouses are already looking at the stresses that a severe climate event can create for their financial resources over the short term (for example, less than five days).”

CFTC principles needed. Concluding the address, Romero made her final proposal: “The CFTC should issue principles describing how the largest regulated entities should address climate-related financial risks through existing risk management frameworks.”

To explain her point, Romero cited banking regulators’ draft Principles for Climate-Related Financial Risk Management (Prudential Principles), which were published in the Federal Register last year. In that document, the Board of Governors of the Federal Reserve System requested comment on draft principles “that would provide a high-level framework for the safe and sound management of exposures to climate-related financial risks for Board-supervised financial institutions with over $100 billion in assets.”

Like the banking regulators, the CFTC should issue principles for managing climate risk, Romero said. “This can help the largest banks, brokers, exchanges, and clearinghouses understand the CFTC’s expectations under existing rules,” she said. “Regulated entities can use principles like these to help assess collateral adequacy or counterparty and third-party service provider risk.”

She concluded: “The Dodd-Frank Act has given regulators the tools to ensure that the financial system is resilient to risk, including climate risk. It is up to us to make full use of those tools, with a sense of urgency as severe climate events are coming faster and costing more.”