Banking Regulation and Climate Change

  • 9 September 2019
  • Blog | Green Finance | Regulation & Compliance | Blog


Climate change is a major threat to the stability of the global economy, as the G20 and the Financial Stability Board (FSB) have both pointed out. Many studies, and individual investment experiences, have demonstrated the links between environmental sustainability challenges and economic and financial risks – which leads to the inconvenient truth that climate change is a systemic threat to financial stability. Bank regulators in some countries are starting to take action but others have yet to take notice.

The Basel Committee on Banking Supervision, the institution charged with international rules and standards covering bank capital, liquidity, corporate governance and risk management practices, has sounded out its members about the relevance of environmental risks to banking stability. But it has not yet taken any action to ensure that banks manage these risks. That omission flies in the face of the evidence showing that environmental risks are: financially material; can create systemic risk to the banking sector; and aren’t factored into the decisions of individual banks. It’s up to regulatory authorities and banking institutions to better manage these systemic risks – which will, in turn, help redirect capital away from unsustainable activities and towards those sectors that are contributing to a more sustainable and stable future.

Incremental steps from banks

Most sustainability risks are negative externalities for the banking sector, since the true societal cost of carbon emissions are not priced by the market. As shown in a 2018 survey by the UK Prudential Regulation Authority, many banks have hitherto only looked at the issue in terms of their Corporate Social Responsibility, rather than business opportunity and risk.  Thus, individual banks are taking mostly uncoordinated and insufficient approaches, managing only the risks they can clearly perceive. The best are mainstreaming sustainability factors into their risk management models and business strategies. This allows them to reallocate capital away from unsustainable economic activities (i.e. industries heavily reliant on fossil fuels) to more sustainable ones (i.e. renewable energy production).

The most advanced banks are also incorporating green credit guidelines and other sustainability measures into their business practices. Two particular areas of interest have emerged. The first is the development of Environmental, Social and Governance (ESG) guidelines for risk management in project finance involving the allocation of long-term credit to renewable energy infrastructure projects. For example, the Equator Principles were established as long ago as 2003 to provide banks with voluntary guidance on incorporating environmental and social risks into their assessments of credit and operational risks in large infrastructure projects.  As a result, many large global banking institutions have mainstreamed environmental governance principles into project finance.

Second, many banks are structuring specialised short-term credit transactions that mobilise more capital for the green economy. Banks are also mainstreaming certain areas of ESG practices into their overall governance strategy. In this way, they are becoming a crucial source of capital for the emerging green economy.
Nevertheless, as economies adapt in response to environmental sustainability risks, asset prices will be volatile, credit will be restricted, and borrower defaults will rise in economic sectors that the market has determined to be environmentally unsustainable. For example, the recent bankruptcy in January 2019 of one of the largest US utility companies – Pacific Gas and Electric – occurred because of the company’s huge losses that arose from extreme weather events (widespread fires and intense windstorms) that resulted in the company filing for bankruptcy, with $52 billion in debt outstanding. 

Evidence suggests that market discipline, on its own, cannot adequately control the externalities in financial markets associated with environmental sustainability challenges. Mark Carney, Governor of the Bank of England, called this “the tragedy of the horizon” because the costs of taking action are borne in the short-run, but the benefits are accrued by future generations.  Combine this short-termism with the relentless political cycle in most countries, and the likelihood of delay in taking appropriate actions for achieving long-term sustainability increases substantially. Delayed actions to avoid a financial and environmental crisis – or to deal with it once it happens – also become costlier.

What role for international regulations?

Some national policymakers have taken steps to incorporate environmental sustainability risks into financial regulation. The UK has decided that managing climate-related risks is a defined function under the Senior Managers Regime, to ensure that very senior managers incur personal responsibility on behalf of the firm. Among a wide range of policies in their action plan, the European Commission is considering whether the EU bank capital rules should incorporate a sustainability factor into the risk weightings (given that such a factor should be risk-based).  China requires banks to take account of sustainability risks in their risk management and business model analyses. China also adopted the Green Credit Guidelines in 2012 that encourage banks to enhance their ESG practices. Similarly, the Central Bank of Brazil requires banks to report on environmental risk exposures and to conduct stress tests for environmental phenomena, while Peru mandates that banks require commercial borrowers to conduct sustainability due diligence assessments for large lending projects.

These policies are largely uncoordinated, however, and experiences suggest that international regulation may have a bigger role to play in developing harmonised standards to incentivise banks to more adequately address these financial risks. That’s the role of the Basel Accord (known as Basel III), administered by the Basel Committee on Banking Supervision, whose members are the bank regulatory authorities from the G20 countries, including the United States. Basel III addresses financial risks in the banking sector through three pillars: Pillar one – Minimum Capital Requirements; Pillar two – Supervisory Review (regulatory); and Pillar three – Market Discipline (disclosure to the market). The three pillars currently do not explicitly take account of the emerging financial stability risks associated with climate change and other environmental challenges.

To address these risks, the Basel Committee should encourage and support national regulators to work with banks in order to adopt best practices in the management of financial risks that derive from unsustainable activities. To achieve this, they should collect the necessary data and conduct analysis to refine the banking sector’s understanding of how much capital and liquidity they should hold against environmental systemic risks. This should include governance and strategy arrangements – at board level; with measurement and disclosure issues including technical matters such as stress testing portfolios using forward-looking scenario analysis.

Regulators can play an especially important role under Pillar two by requiring banks to conduct such stress tests to estimate the potential financial stability impact of supplying credit to environmentally sustainable or unsustainable activities over time.

Under Pillar three, regulators can assess the feasibility of requiring banks to disclose information about their exposures to, and management of, environmental systemic risks, perhaps consistent with the 2017 recommendations from the FSB’s Task Force on Climate-Related Financial Disclosures.  It is important that such disclosures are comparable across banks and jurisdictions. The Basel Committee has a duty to determine that whatever regulatory standards they adopt are standardised across countries.

Banking executives tend to lobby reflexively against the idea of new regulation, citing their professed market discipline and risk management protocols. But policymakers should remember what Alan Greenspan told the US Congress in the wake of the Financial Crisis in 2008: “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Regulatory intervention, if not calibrated properly, can produce market distortions that can result in further externalities and misallocations of capital and investment. So, a careful combination of market innovation and policy frameworks that suit national circumstances may be needed. As banks are the largest providers of credit for most economies, how they manage these risks is an important policy and regulatory concern. International regulators have an important role to play in coordinating improved bank risk management.

Finally, one could argue that at this current juncture, a shortage of capital supply is not the biggest challenge in financing a sustainable economy, since there are already a growing number of large investors and asset managers seeking to move their portfolios towards sustainable returns. Rather, the problem is that there are insufficient green/low-carbon projects being undertaken that require financing. Hence we actually have a shortage of green assets available to invest in. Green bonds that are issued seem to fly out of the door and issues are often upsized, whilst pricing is kept very tight. But banks can help create their own business opportunities, particularly for smaller corporates and at consumer level, by tapping latent demand through advertising and pushing new products. Part of the motivation for that has to come from the realisation that some existing industries currently financed by banks – like the coal industry – are simply going to be phased out in the economy’s transition to a more sustainable footing. The banks that understand these trends will be those who are the most sustainably successful themselves.

Read more from the Sustainable Finance Report here.