Climate risk to community banks will rise just as oversight wanes

Next year, the Office of the Comptroller of the Currency plans to roll back supervision of community banks, and the impact of that decision could create a new blind spot for a financial system increasingly vulnerable to the impacts of climate change. The idea that smaller and less complex banks require less regulatory oversight is all but conventional wisdom. But as the impacts of climate change on the financial system increase, relaxing supervision of community banks is a mistake. Small, geographically constrained banks, particularly in climate-vulnerable communities, face risks that large, complex and diversified banks do not. Regulators must remain responsive to these risks, rather than neglecting them due to an institution’s size.

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Climate change is responsible for a mounting set of risks to banks and other financial institutions. Increasingly frequent, severe and costly climate disasters are driving property insurers out of vulnerable geographies; mortgage lenders in these areas face the prospect of growing losses on underinsured properties when disasters hit; and banks lending to climate-risky sectors are exposed to physical and transition risks through their loan portfolios. Earlier this year, Federal Reserve Chair Jerome Powell testified at a Senate Banking Committee hearing, that due to climate change, “if you fast forward 10 or 15 years, there will be regions of the country where you can’t get a mortgage, there won’t be ATMs, banks won’t have branches and things like that.”

Under the Biden administration, bank regulators began taking note of these risks. In 2023, the Federal Reserve, Federal Deposit Insurance Corporation, and OCC issued Principles for Climate-Related Financial Risk Management — a framework for the supervision of climate-related financial risks — and in 2024 the Fed published the results of its Pilot Climate Scenario Analysis Exercise, undertaken to understand bank exposures to climate risks and their ability to manage them.

These efforts — before they were abandoned by the Trump administration — were preliminary, but important steps to address climate risk in the banking system. One of their limitations, however, was their focus only on the risks faced by the largest banks. The climate risk principles applied to banks with over $100 billion in assets and the Fed’s climate scenario analysis exercise was conducted with only the six largest U.S. banks. Regulators ignored both the risks faced by smaller institutions as well as the risks the largest banks create for the broader financial system.

Focusing on climate risks faced by large, complex and interconnected banks is certainly a logical first step. These banks, should they become financially impaired, could set off a cascade of chaos across the financial system and real economy. But the largest and most sophisticated banks also have channels to offload risks to other financial institutions, investors and the public that community banks do not.

Community banks, though alone are less central to the stability of the financial system, face climate risks that the largest banks do not, in part due to their relative simplicity. While the largest banks can diversify lending away from climate risky geographies and sectors, community banks frequently operate in a fixed geography and are unable to diversify lending away from climate risks. While the largest banks can offload commercial loans made to climate-risky companies onto investors, these channels are far more limited for community banks. Through capital markets activity, advisory services and investment management, the largest banks have also diversified their revenue streams away from balance-sheet intensive activities. 

Community banks are also responsible for the vast majority of agricultural lending — one of the sectors most exposed to the physical risks of climate change. Changes to temperature and precipitation patterns are expected to reduce crop yields and change the geographic landscape of agricultural production. With these changes come financial risks to firms and in turn to lenders. As of 2023, the FDIC estimated that 69% of loans to the agricultural sector in the U.S. were held by community banks. Constraints on the geographic reach and business lines of community banks also means these lenders are more likely than their large bank counterparts to continue lending to the agricultural sector, even in the face of extreme weather.

Rolling back supervision has support from the community bank lobby, but any benefits from the reduction in oversight are a temporary reprieve for a long-term problem which neither regulators nor banks have prioritized. If Chair Powell is correct and in 10 to 15 years there will be regions of the country where mortgages and other financial services are unavailable due to climate change, it means that the community banks that serve these regions will no longer exist, or will be actively shrinking as the geographic footprint of climate change grows.

Ensuring the long-term viability of community banks and continued access to financial services in the communities these banks serve requires more than a blanket deregulatory approach. Supervisors should work with community banks to manage their exposures to climate risks and promote continued access to financial services, including in climate-vulnerable geographies.

Preserving a viable community banking system also requires addressing the risks the largest banks create for the rest of the financial system, not just the ones they hold on their own books. When regulators assess climate risk on an institution-by-institution basis, rather than managing risk in the financial system as a whole, they set off a game of hot potato that community banks are destined to lose.

Following the global financial crisis, regulators placed guardrails on risky lending banks originated but distributed to other actors in the financial system. Bank regulators should require similar guardrails for climate-risky activities to ensure big banks cannot profit off of adding risk to the financial system that less sophisticated entities or the public writ-large will bear.