Climate Risk Management vs. Community Development Lending: NYDFS Wants Its Banks and Mortgage Companies to Do Both

On December 21, 2022, the New York Department of Financial Services (“NYDFS”) proposed guidance for how the banks and mortgage institutions it regulates (“New York Institutions”) should manage climate-related financial risks (the “Proposed Guidance”).¹ The Proposed Guidance would establish extensive obligations for New York Institutions, which, even if tailored to be proportionate to size and activities, could create a significant burden. This is particularly true for mortgage bankers and mortgage servicers, which historically have not been subject to the same risk management expectations as banks.

NYDFS will accept comments on the Proposed Guidance until March 21, 2023, and requests that commenters use a specially formatted spreadsheet from the agency’s website to format submissions. In this Legal Update, we provide background on the NYDFS’s climate risk management initiative and discuss the Proposed Guidance.

Background

NYDFS is the primary regulator for many categories of financial institutions that do business in New York, including New York Institutions.² As with the federal prudential regulators, NYDFS is charged with promoting the safety and soundness of New York Institutions. In recent years, safety and soundness principles have been construed as including the establishment of enterprise-wide risk management systems, although the risk management expectations for mortgage bankers and mortgage servicers are not as well-defined or extensive as for banks. However, this situation may be changing, as evidenced by the release of model state regulatory prudential standards for nonbank mortgage servicers by the Conference of State Bank Supervisors.³

In 2020, NYDFS identified climate change as a driver of risk for the financial institutions that it regulates. This is consistent with the focus of other regulators, such as the Federal Housing Finance Agency (“FHFA”), on climate change.⁴ In October 2020, NYDFS released initial guidance to New York Institutions on how to manage the financial risks from climate change. This was followed in November 2021 by climate risk management guidance for New York insurance companies, which we discussed in an earlier Legal Update. It seemed likely, however, that NYDFS would revisit the climate risk management guidance for New York Institutions, particularly given federal and international developments on these issues.

Proposed Guidance

The Proposed Guidance would expand on the 2020 guidance by establishing a comprehensive framework for managing climate-related financial risk. As with guidance from other regulators, the Proposed Guidance defines climate-related financial risk as consisting of physical risks and transition risks and states that New York Institutions should consider the effects of each of these types of risks on their operational resilience and their safety and soundness and the particular consequences these risks may pose to their customers.

The Proposed Guidance identifies two “overarching themes” to climate risk management: (i) managing climate-related financial risks while complying with fair lending obligations in low- and moderate-income (“LMI”) communities and communities of color, which may be disproportionately harmed by climate change and natural disasters, and (ii) taking a proportionate approach to the management of climate-related financial risks. The first theme is intended to ensure that New York Institutions manage climate-related financial risk in a way that minimizes and affirmatively mitigates adverse impacts on LMI communities and communities of color. This theme may generate considerable comment given the difficulties financial institutions can encounter in managing both fair lending and safety and soundness concerns. It also is notable because NYDFS makes the point elsewhere in the Proposed Guidance that New York Institutions cannot assume that insurance will be available or affordable to mitigate the costs associated with climate change. If climate change will render some financial products unavailable to financial institutions, one might wonder why it would not make some financial products unavailable or cost prohibitive to consumers.
The Proposed Guidance describes the components of prudent climate risk management as:

1. Corporate Governance: A New York Institution’s governing body and management should establish a governance framework that will ensure there is a process in place for identifying, measuring, monitoring, and controlling the institution’s financial risks associated with climate change. This includes appropriate strategy and risk oversight activities as well as enterprise-wide policies and procedures and controls.
2. Internal Control Framework: A New York Institution should incorporate climate-related financial risks into its internal control frameworks across the three lines of defense, to ensure sound, comprehensive, and effective identification, measurement, monitoring, and control of material climate-related financial risks.
3. Risk Management Process: A New York Institution should identify, measure, monitor, and control climate-related financial risks through its existing risk management framework, including through appropriate approaches to mitigate risks. It appears that climate risk should be embedded in an institution’s existing risk categories (e.g., as part of credit risk, not a standalone risk).
4. Data Aggregation and Reporting: A New York Institution should develop proportionate risk data aggregation capabilities and risk reporting practices that are capable of monitoring material climate-related financial risks and producing timely information to facilitate board and senior management decision-making.
5. Scenario Analysis: A New York Institution should consider using a range of climate scenarios based on assumptions regarding the impact of climate-related financial risks over different time horizons to assess the resiliency of its business model and strategy, identify and measure vulnerability to relevant climate-related risk factors, estimate exposures and potential impacts, and determine the materiality of climate-related financial risks. This expectation may come as a surprise to mortgage bankers and mortgage servicers, which historically have not been expected to conduct scenario analysis or stress testing as part of risk management.

Takeaways

The Proposed Guidance requests comment on a timeline for implementation of its expectations and how to tailor scenario analysis activities for smaller institutions. It also asks if there should be climate-specific reporting and disclosure requirements for New York Institutions. All of these are issues that have been raised in relation to the proposed climate risk management expectations from the federal banking regulators and are likely to generate similar comments to NYDFS.

The Proposed Guidance is likely to generate new controversy for its statements that New York Institutions “must manage climate-related financial risks prudently while continuing to ensure fair access to capital and credit” and may not implement risk management practices that “unduly harm or disadvantage at-risk communities.” While the Proposed Guidance states that NYDFS will not dictate credit or investment decisions, the imposition of a fair access requirement arguably could be viewed as going further than existing fair lending and community reinvestment requirements if institutions are obligated to make certain products available.⁵ As was seen with the fair access rulemaking by the Office of the Comptroller of the Currency, this type of supervisory expectation is not common in the United States and raises a host of regulatory and policy concerns.

¹ NYDFS, DFS Superintendent Harris Proposes Guidance for New York State-Regulated Banking and Mortgage Institutions Relating to Management of Safety & Soundness Risks From Climate Change (Dec. 21, 2022), https://dfs.ny.gov/reports_and_publications/press_releases/pr202212201. New York Institutions include New York-regulated banking organizations, New York-licensed branches and agencies of foreign banking organizations, and New York-regulated mortgage bankers and mortgage servicers.

² See, e.g., N.Y. Banking L. §§ 14, 44.

³ Press Release, CSBS Releases Model State Regulatory Prudential Standards for Nonbank Mortgage Servicers (July 26, 2021).

⁴ See our Legal Update on the FHFA action: https://www.mayerbrown.com/en/perspectives-events/blogs/2021/12/fhfa-releases-statement-on-climate-change. See also our Legal Update on the impact of climate change on the regulated US mortgage industry: https://www.mayerbrown.com/en/perspectives-events/publications/2021/11/climate-change-impacts-to-the-us-mortgage-industry.

⁵ See our discussion of climate redlining in relation to the federal Community Reinvestment Act rulemaking: https://www.mayerbrown.com/en/perspectives-events/publications/2022/03/climate-risk-management-and-community-reinvestment-in-the-us-competing-or-complementary-priorities.