Enhanced data and climate-risk economic analysis, combined with broad international agreement, make it impossible for financial institutions to ignore the critical link between climate change and the financial system.
Even some of President Donald Trump’s conservative regulators now see climate change as an urgent issue within their purview. Under the existing authority, regulators could use a variety of policy levers to mitigate climate-related financial risks and ensure the financial system acts as a source of strength for the economy during the clean energy transition. The bank capital framework is one of the most effective tools in financial regulators’ arsenal. That would be at the heart of attempts to improve the financial system’s resilience to climate-related risks.
To be more specific, financial regulators should take five capital-related steps to mitigate climate-related financial risks:
- Capital risk weights should be adjusted for bank exposure levels that face intense transition risks.
- Implement a capital surcharge for macroprudential climate risk contributions.
- Create long-term climate stress assessments and supplement existing stress tests with near-term climate variables.
- Add transition and physical risks to capital risk weightings.
- Climate risks should be followed in the shadow banking system.
Financial risks associated with climate change and a precautionary approach
Financial risks associated with climate change and the precautionary principle Physical and transition risks are the two major transmission channels through which climate change could harm financial institutions and markets.
The Federal Reserve has established a framework for analyzing financial stability risks resulting from shocks and vulnerabilities in the macro-prudential policy. Shocks are endogenous or exogenous events that cause financial system losses or disruptions, such as a cyberattack, a trade war, or an asset price bubble burst.
Climate change has consequences for both types of macroprudential considerations because it will cause more frequent and intense physical shocks. In addition, the transition to a low-carbon economy may cause shocks to carbon-intensive assets.
Climate change also adds to the structural vulnerabilities of the financial system. For example, stress could spread throughout the financial system if climate-related transition or physical shocks cause significant losses at a systemically important financial institution or strongly linked losses among smaller financial firms.
One of the most critical lessons policymakers should have taken away from the 2008 financial crisis is the importance of using the precautionary principle when trying to regulate the financial system. Unfortunately, however, there is considerable uncertainty about the timeframe of climate-related financial stability risks, the absolute magnitude of the economic value at risk, and the precise manifestation of those risks across various financial assets, markets, and institutions. All of the actions mentioned above are crucial and essential. Still, regulators should not allow uncertainty about precise climate effects or the precise future path of the clean energy transition to halt action today. The financial system’s possible harm is too great for regulators to wait, and given the complexity of this risk, a substantial level of uncertainty will persist.
Solid financial regulatory policies that strengthen the financial system’s resilience to climate-related dangers would be a type of economic stabilization insurance. Combating the climate crisis necessitates a multi-agency approach. International regulators have recognized the gravity of these climate-related dangers and the need for financial regulators to take action. The Network for Greening the Financial System (NGFS) was founded in December 2017 by eight central banks to serve as a coordinating body for central banks and supervisors committed to addressing climate-related financial risks. Since then, the NGFS membership has grown to 90 members and 13 observers, representing more than 85% of global GDP and the overwhelming majority of the world’s systemically important financial institutions. 23. Many NGFS members have begun to modify their core regulatory and supervisory frameworks accordingly.
The Federal Reserve announced its intention to join the NGFS in December 2020, but it remains the only federal financial regulator in the United States to do so. The absence of international engagement on this issue undermines the United States’ role as a leader in both climate and financial services policy. In addition, federal regulators in the United States have yet to take meaningful steps to incorporate climate risk concerns into their regulatory and supervisory frameworks.
Some appointed regulators have advanced policies discouraging financial institutions from taking account of climate risk. Under the authority, regulators should use various policy tools to strengthen the financial system’s resilience to climate-related hazards and averting financial institutions from exacerbating risks. The bank capital framework, arguably the most significant pillar of banking regulation, is one less-discussed but powerful regulatory tool.
Incorporate the climate into existing and new stress tests.
Financial regulators, markets, and the general public lack an adequate understanding of how particular financial institutions and the financial system would fare in the face of a variety of severe physical and transition-related shocks. As described throughout this report, regulators have more than enough details to take solid, proactive measures to mitigate these risks. Still, supplementary policy interventions would benefit from a more granular assessment. Furthermore, financial institutions are not adequately integrating long-term climate risks into their fundamental business and risk decisions.
The Federal Reserve should institute climate-related stress tests to assess large banks’ resilience to moderate- and long-term physical and transition shocks. As part of this exercise, banks must disclose remediation plans outlining how they will modify their balance sheets over time to prevent severe losses. The Fed should also include near-term climate-related variables in the existing nine-quarter annual stress tests and set supervisory expectations for banks that require them to incorporate climate-related threats into their governance, risk management, internal controls, capital planning, and self-run stress tests.
Supervisory expectations regarding climate change
As Fed Governor Lael Brainard recently stated, supervisors must make sure that financial institutions are adaptable to all material risks and those related to climate change, both now and in the future. Accordingly, climate risk must be integrated into banks’ governance, management, internal controls, capital planning, and self-run situation analyses.
The board of directors and senior management should certainly assign responsibilities for climate-related risks within the bank’s governance structure. However, this issue necessitates attention at the bank’s highest levels to ensure that climate-related considerations are appropriately integrated throughout the bank’s core business and risk activities.
Climate change-related physical and transition-related risks pose serious credit, market, liquidity, reputation damage, and operational risks to many banks. Therefore, banks must account for these threats in their core risk management frameworks.
Banks must implement policies and procedures to monitor climate-related factors in core risk and business functions closely. Strong internal controls can assist the bank in monitoring the efficiency of climate-related risk management, governance, capital planning, model use, conformance, audits, and other functions and addressing any apparent shortcomings promptly.
Climate-related risks should be considered part of the ordinary capital planning process, wherein banks evaluate their capital needs and decide how to manage their capital resources.
While the Fed should develop prudential stress tests, banks should be required to undertake their stress tests and scenario analyses. The Fed will only use a small subset of the thousands of possible climate-related scenarios. Therefore, banks must consider and make an effort to try to model a wide variety of possible scenarios.
So, to fulfill the above expectations, regulators must invest in increasing internal climate capacity and ensure that examiners are well-trained. In addition, bank regulators in the United States should aspire to learn about climate-related supervision guidelines from their international counterparts. Incorporating climate risk into the ongoing supervision will supplement the development of new climate-related regulations.
Why do the banks hesitate?
Why are bank regulators opposing the proposed Basel Committee on Banking Supervision guidance, the standard-bearer for global risk issues since the 2008 financial collapse?
The BCBS recommendations, which were floated last fall for industry comment until last month, include a provision requiring bank supervisors to have climate threats in the stress testing that banks currently undergo. But, wait a minute, says the American Bankers’ Association in response. While the ABA “theoretically agrees” with the BCBS assumption that climate-related risk should be considered, it believes that certain proposed principles are “overly restrictive.”
They argue that including the consequences of climate events in financial risk assessments is “premature and counterproductive.” The ABA’s comments have real clout because it is the most significant economic trade group in the United States and the official “voice” of the $23.3 trillion banking industry. The FSF contradicts the BCBS proposal’s climate stress testing because it could “foreseeably result in adverse regulatory consequences for banks.”
Four hundred fifty global financial firms, able to represent $130 trillion in assets, have pledged to achieve net-climate neutrality by 2050. Despite the industry’s primary lobbying groups’ current opposition to what appear to be pretty basic climate risk principles, some US banks continue to participate in progressive initiatives.
In addition, the state’s Department of Financial Services will issue new guidelines for how state-regulated banks should perceive climate risk. Commitments and principles for US banks, like climate change itself, will continue to increase the bar for managing climate risk.
Why should you address the issue now?
These policy suggestions focus on escalating bank capital requirements to alleviate various climate-related financial system risks.
It is worthwhile to address the second half of the international climate-bank capital debate on the treatment of green assets in the capital framework. Some have argued that, in addition to enhancing risk weights for dirty assets or assets exposed to climate risks, current risk weights for green assets should be reduced to encourage green investment. The primary goal of a bank’s capital stipulation should be to protect against risk, not to promote specific investments.
There is no evidence that green projects are less risky than some other types of corporate exposure. Significantly reducing prudential regulatory requirements for exposure levels that are not less risky would jeopardize financial institutions’ safety and soundness and could threaten financial stability.
Numerous financial regulatory tools, such as the Community Reinvestment Act, are probably more suited to driving green investment directly. Furthermore, public investment and well-designed public-private partnerships can play a critical role in ending the green financing gap. Finally, it’s also worth noting that increasing the cost of borrowing for dirty investments to reflect better their riskiness reduces the comparative cost of funding for green assets and will implicitly drive green investment, even if that isn’t the primary goal.
A category of investments that consciously remove carbon dioxide from the atmosphere, including natural climate solutions or direct air capture projects, maybe an exception to this principle. As per the Intergovernmental Panel on Climate Change, maintaining net-negative global emissions will be required to stabilize global warming. Therefore, regulators should be open to arguments that specific exposures to damaging emission projects can substantively reduce climate change’s physical risks and warrant more favorable treatment under the capital framework if their effectiveness is reliably demonstrated over time without causing other harm. Such investments would have a positive externality because they would minimize potential physical risk-related damage to the entire financial system.
Financial regulators must act quickly to mitigate the potential impact on the financial system. Regulators would be failing to fulfill their regulations and statutory requirements if they deliberately ignored these risks and allowed them to fester. While various policy tools should be used to protect the financial system from climate-related threats, the capital framework is a core component of banking regulation. It should be a cornerstone of these efforts.
The consequences of climate change are already visible, but the worst-case scenarios fall outside policymakers’ typical decision-making window. Mark Carney, a former Governor of the Bank of England, has referred to this quandary as the “Tragedy of the Horizon.” Integrating climate threats into different elements of the capital framework will go a long way toward minimizing climate risks and protecting the economy from a climate-driven financial crisis.
While regulators could take several steps to achieve these goals within the capital framework, various supplementary financial regulatory tools should always be used. Climate considerations must be thoroughly integrated into the financial regulatory framework by regulators. Although these climate risks are complex, regulators should not need to spend the next few years researching them before taking action. Given the high likelihood of climate change and the magnitude of potential financial losses, regulators should take a precautionary approach and take immediate action.
These are purely the opinions of the author based on observations and analysis of financial platforms and a study of public reviews and ratings on how the capital rules for climate risk are being opposed by US banks. Excerpts from various sources have been used to clarify the facts in this article. A glossary of all the sources used can be found at the end of the article. This article is for educational purposes only and is not financial advice.