The Fed has a clear mandate to mitigate climate risks

In a Senate Banking Committee hearing last week, ranking member Sen. Pat Toomey (R-Pa.) warned the Federal Reserve against “stray[ing] from its mandate” by addressing “politically-charged areas like global warming.” 

“If this politicization continues unchecked,” the senator threatened, “it will not end well for the Fed.” 

These comments are clearly targeted at the likes of Sarah Bloom Raskin, President Biden’s nominee to be the Federal Reserve’s chief bank regulator, who has publicly called for the institution to ensure a smooth transition to a low-carbon economy without disruptions to the financial system.

Toomey is just plain wrong. Addressing banks’ climate risks is core to the Federal Reserve’s legal mandate. In fact, to ignore climate change and the risks it poses would be contrary to their congressionally given mandates. Doing so would not end well for the Fed — or the economy.

Long ago, Congress recognized that a strong economy needs a sturdy and inclusive banking system. Banks help savers build wealth, provide loans to entrepreneurs to start and grow businesses and allow the Federal Reserve to target full employment and reduce inflation by transmitting monetary policy decisions to the rest of the economy. Consequently, Congress tasked the Federal Reserve and its fellow federal banking regulators with ensuring banks do not operate in an “unsafe or unsound condition,” responding to “emerging threats to the stability of the United States financial system,” and encouraging banks “to help meet the credit needs” of their communities, among other requirements.

Ensuring banks can weather the climate crisis is key to the Federal Reserve fulfilling these legal obligations, as climate-related risks are a new form of systemic risk that can have severe consequences on financial stability. According to the National Oceanic and Atmospheric Administration, the United States saw “20 separate billion-dollar weather and climate disasters” in 2021 with damages totaling about $145 billion, and there is little doubt those disasters affected the financial system. Banks face exposure to climate-related risks from acute and chronic physical damages and productivity losses, known as physical risk, as well as from the ongoing transition away from high-carbon industries and growing legal liability, known as transition risk.

Importantly, these twin risks map directly onto the traditional categories of financial risks that banks face — and must manage — with every loan. A farmer who borrowed to buy a new tractor, for example, may be unable to repay the loan if her crops are destroyed by increasingly strong storms (i.e., credit risk). Or a loan to an oil and gas company may be left unrepaid as the costs of solar become cheaper and fossil fuel infrastructure become obsolete (i.e., market risk). Or a bank’s headquarters and computer servers may be at risk from extreme flooding or wildfires (i.e., operational risk). 

Regardless of whether a bank has failed because of climate change, theft, or simple mismanagement, it cannot take deposits, make loans, or otherwise support the economy. And despite Toomey’s claims to the contrary, climate risks are squarely within the Federal Reserve’s statutory mission of ensuring a stable financial system.

Because climate change poses risks similar to those banks routinely face — such as credit, market, and operational risks — the Federal Reserve can take routine actions to ensure that banks are well-equipped to tackle climate change, including issuing climate supervisory guidance and conducting climate scenario analyses.

The Federal Reserve regularly provides banks with supervisory guidance to identify developing risks that banks face and offer examples of practices that can be used to lessen those risks. As banks begin to tackle climate change, the Federal Reserve should issue supervisory guidance helping them understand the climate risks they face and options for mitigating those risks. And because Federal Reserve examiners annually rate banks on a number of factors, known as CAMELS ratings, the Federal Reserve should update its examination manuals to detail how its examiners will incorporate climate risks into those ratings.

Similarly, after recognizing that the failure of some banks during the 2008 financial crisis could cause harm to the broader financial system and real economy, the Federal Reserve began regularly testing large banks to understand their susceptibility to failure in times of stress. Because the potential consequences to the financial system from climate change are similar to those of financial crises — failing banks leading to a pullback of credit — the Federal Reserve should perform climate scenario analyses to evaluate banks’ susceptibility to failure due to climate risks in the future.

Importantly, the Federal Reserve legally cannot tell banks to divest entirely from certain lines of business, such as loans to oil and gas companies. What it can and should do, however, is ensure banks understand the risks they face and help prevent those risks from leading to bank failure and propagating through the rest of the financial system and real economy. Fortunately, many of the nation’s largest banks, including Bank of America and JPMorgan Chase, and some small- and mid-size banks have made the voluntary decision to decarbonize without the need for regulatory pressure.

Although Toomey wants the Federal Reserve to avoid politics and adhere to its statutory mandate, doing so requires officials to address climate risks within the banking system. Fortunately, Federal Reserve leadership recognizes this, based on deep and thorough research: During his renomination hearing last week, Chairman Jerome Powell responded to a question about climate risks by stating, “We have a role to play. It’s a narrow one, but an important one, and that is it relates to our existing mandates.”

Todd Phillips is the director of financial regulation and corporate governance at the Center for American Progress.