Paul H. Kupiec
In a 2020 article published in the Cornell Journal of Law and Public Policy, Graham Steele described a detailed plan to use federal financial regulatory agency powers to implement a new national industrial policy without legislation. The plan was to use the powers of the financial regulatory agencies to restrict the flow of credit and capital to firms and activities that produce greenhouse gas emissions.
The plan uses the Financial Stability Oversight Council (FSOC) to declare climate change as a systemic risk, which in turn requires FSOC members to use their Dodd-Frank regulatory powers to impose new regulations to mitigate the alleged climate-change systemic risk threatening the financial system.
Climate-change regulations would take the form of heightened capital requirements for bank loans to greenhouse gas (GHG) intensive firms and activities. These higher capital requirements will be justified by claiming that climate-change factors elevate the future credit risk profile of targeted borrowers.
According to Steele, to limit GHGs, regulators will also increase minimum collateral haircuts and margin requirements on capital market transactions and place new regulatory caps on the total amount of GHGs that can be emitted by the firms whose securities are held by mutual funds, pension funds, public investment companies, and insurance companies. These caps could require divestitures. These new heightened regulatory restrictions would be applied to counterparties from specific targeted industries.
To quote Steele,[C]apital rules can be updated to increase risk weights on the basis of climate risk to reflect the potential for capital intensive losses based on financial climate risks. Risk weights could be increased for loans and investments in climate change-driving assets, as well as credit exposures to sectors that are vulnerable to the effects of climate change. These risk weights would apply, at a minimum, to all financing of the industries that encompass the 100 producers that, as of 2017, accounted for 71 percent of global industrial greenhouse gas emissions, as well as agribusinesses operating in areas that are sensitive to deforestation, to better reflect the true costs and risks from the climate impacts of these investments.
Time has revealed this plan is the actual blueprint for implementing an important component of the Biden administration’s net-zero policies.
A cardinal rule of financial regulation is that you can’t regulate a risk unless you can measure it. The risk measure in this case will be provided by the SEC. Its March proposal requires all public companies to periodically disclose their scope 1, 2 and 3 GHG emissions measured using the GHG Protocol. Public companies’ scope 1 and 2 emission estimates, and eventually scope 3 estimates, must be “certified” by an appropriate third-party climate-change consultancy. Marketed as a measure to satisfy the information needs of a “confused” Environmental, Social, and Governance (ESG) investor community, the rule focuses on GHG emissions disclosures and neglects other issues ESG investors purport to champion.
This diabolically destructive plan uses the ambiguous language of the poorly drafted Dodd-Frank Act to hijack financial regulatory powers to disrupt nonfinancial companies that are disfavored by the current administration as a means to implement a new national industrial policy. The plan is an abuse of Executive Branch power that usurps powers vested in the duly elected representatives in Congress.
Following the 2008 financial crisis, the Dodd-Frank Act created new financial regulations designed to mitigate financial “systemic risk.” But by oversight or design, the Act never defines systemic risk notwithstanding the 39 times the term appears in the 849-page legislation.
The Act requires the Federal Reserve to impose new regulations to mitigate the systemic risk created by large complex financial institutions designated in law as “systemically important financial institutions.” It also allows that, by virtue of their corporate structure, activities, or practices, other financial institutions could be sources of system risk if so deemed by the FSOC.
By never defining the term “systemic risk,” the Act creates ambiguity the FSOC can exploit to designate institutions, activities, or practices as a source of systemic risk—a designation that requires federal financial regulatory agencies to promulgate new regulations to mitigate the risk. True to plan, the administration has capitalized on this loophole by having the FSOC conclude that climate change is, ”a systemic risk to the financial sector.”
Keep in mind that Congress never granted the executive branch or independent financial regulatory agencies the power to regulate nonfinancial firms. The systemic risk provisions of the Dodd-Frank Act apply to federally regulated banks, financial institutions, and to nonbank financial institutions designated to be “systemically important” by the FSOC. The latter must be nonbank companies ‘‘predominantly engaged in financial activities.’’
The FSOC report on climate-change risk essentially argues that the companies emitting GHGs are the ultimate source of systemic risk. But these companies are predominantly nonfinancial in nature and consequently not subject to the provisions of the Dodd-Frank Act. The administration circumvents that problem by arguing that they have not designated the emission-intensive firms as systemic, but instead have determined that these firms carry heightened credit risk as a consequence of so-called “climate-change transitional risk.” Transition risk is a hypothetical credit-risk multiplier linked to GHG emissions.
Transitional risk is the risk that a firm’s revenues or costs could be negatively impacted by future government policies or regulations (a.k.a. political risk), or because of diminished demand as a consequence of changing consumer preferences. The ambiguous concept of transitional risk is wholly conjectural and not based on specific historical experiences. The concept of hypothetical transition risk could be applied to any firm to justify any political goal.
Climate-change stress tests are the favored “regulatory tool” of those who fear Greta Thunburg’s ire and hypothetical climate-change transition risk. In these stress test exercises, regulators force banks to estimate the losses that they might accrue in the distant future should climate change somehow catalyze the modern day equivalent of the Old Testament plagues unleashed on the Egyptians that in turn trigger government policies or demand changes that limit GHG-intensive industries ability to continue operations.
The Fed—an institution that, time and again, has proven that it cannot forecast the inflation rate or GDP growth over the next three months let alone years into the future—gets to decide what level of individual bank losses are “accurate” in these hypothetical climate apocalypse scenarios. The Fed is also the judge of whether the bank will have sufficient capital in the future to absorb these fictional losses.
Banks cannot dispute the assumptions of the Fed’s imaginary catastrophic scenario, nor can they dispute the accuracy of the Fed’s bank-specific loss estimates because, as a practical matter, the stress test exercise is repeated on a periodic basis, and in the next round, the Fed will still be the bank’s regulator.
If, as a matter of legal convention, we do not convict alleged speeding violations when the traffic radar measurement has not been certified as accurate, how can we convict banks of regulatory transgressions based on estimates from a Fed-run econometric simulation exercise whose accuracy cannot be objectively verified? Common sense suggests that such rules invite arbitrary and capricious exercises of power and indeed the courts have upheld this commonsense view.
In 2014, the FSOC designated MetLife Inc. a systemically important nonbank financial institution based on a hypothetical stress test analysis. The FSOC argued that, should MetLife policyholders experience a loss of confidence in it, MetLife could experience a bank-like run among its policyholders. The run could trigger its bankruptcy and create widespread losses for other financial institutions.
Despite the fact that there was no historical evidence that any insurer similar to MetLife ever experienced such a calamity because insurance company policyholders do not run like bank depositors, the FSOC insisted that this narrative provided conclusive evidence that it posed a systemic risk to the financial sector. MetLife fought the designation using the Administrative Procedures Act and successfully prevailed when the court found the determination to be arbitrary and capricious.
The use of climate-change transitional risk to impose extra-legal regulatory sanctions on specific industries and activities repeats a previous Democratic administration’s abuse of financial regulatory powers. In the illegal “Operation Choke Point,” the Obama administration’s DOJ teamed up with the FDIC under chairman Martin Gruenberg to pressure banks to cease doing business with, among other industries, gun shops, payday lenders, and legal purveyors of fireworks and pornography. The justification was that such businesses had a high probability of being involved in money laundering and other fraudulent activities. Authorities argued that when these activities are discovered, a bank will suffer damage to its reputation which could negatively impact its business, as well as invite regulatory sanctions for violating anti-money laundering regulations.
When the legality of Operation Choke Point was questioned by Congress, the DOJ abandoned the operation. A group of payday lenders subsequently sued the FDIC arguing that the FDIC illegally used regulatory guidance regarding reputation risk “as the fulcrum for a campaign of backroom regulatory pressure seeking to coerce banks to terminate longstanding, mutually beneficial relationships, with all payday lenders.” A DC federal court denied the FDIC’s motion to dismiss the suit and plaintiffs won a settlement in which the FDIC admitted that “certain employees acted in a manner inconsistent with FDIC policies with respect to payday lenders…”
Like this historical abuse of the ill-defined concept of “reputational risk,” using climate-change transitional risk as a justification for choking off lending and capital to companies involved in activities that are legal but disfavored by the current administration is an abuse of regulatory power.
There are three legal avenues I know of that could be used to challenge any new climate-change financial regulations that seek to choke off credit and capital to greenhouse gas intensive companies.
The quickest, most straightforward way to overturn any new climate-change systemic risk regulations would be for Congress to pass a disapproval resolution using its powers under the Congressional Review Act. If, within a short period following the publication of the final regulation, 30 senators sign a petition to consider disapproval, debate on the motion is limited, and the resolution would receive a Senate vote. Should the resolution also pass the House, the President’s signature is required to vacate the regulation.
Should the Republicans carry the midterm elections, the 118th Congress could pass new legislation that overturns any new emissions-focused financial regulations imposed by the administration. Again, legislation would have to be signed by the President before becoming law. Clearly, both Congressional approaches face long odds of success under President Biden.
As MetLife demonstrated, an FSOC systemic risk determination can also be successfully challenged under the Administrative Procedures Act. This of course takes time, imposes significant costs on a plaintiff, and requires a plaintiff to have legal standing. I leave it to experts to argue who might have legal standing in this situation. Still, the point remains, that the FSOC can be beaten.