Can Banking Regulation Address Climate Change?

by kern alexander
Kevin Frayer/Getty Images

kern alexander is Professor of Law and Finance at the University of Zurich. He was appointed by the G20 and the United Nations in 2016 to lead a research effort and write a report for the G20 on banking policy, regulation and environmental sustainability. His most recent book is Principles of Banking Regulation (Cambridge University Press, 2019).

Published June 18, 2019


Policymakers are tasked with keeping a close eye on systemic risks to financial stability. But banking’s regulators seem to have a blind spot when it comes to climate change and the financial risks it poses. Just ask the lenders to PG&E, which listed $52 billion in debts when it declared bankruptcy on January 29.

Climate change is a major threat to the stability of the global economy, as the G20 and the Financial Stability Board have both pointed out. Studies have demonstrated the links between environmental sustainability challenges and economic and financial risks — which lead to the inconvenient truth that climate change is a systemic threat to financial stability.

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 taken action to encourage banks to manage these risks. That omission flies in the face of studies that show that these 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 environmental systemic risks — and at the same time redirect capital toward sectors that are contributing to a more sustainable future.

Baby Steps from Banks

Most sustainability risks are negative externalities for the banking sector; the true societal costs of carbon emissions are not priced by the market. Thus, individual banks are taking uncoordinated — and largely insufficient — approaches to managing only the risks they perceive. A few government-industry bodies (e.g., the Sustainability Banking Network) work with global banks and regulators to address the challenges of environmental, social and governance (ESG) risks and to adopt uniform principles and standards to manage them. But these efforts are limited to a few global banks; the banking industry generally follows disparate approaches to managing these risks.

Some banks are mainstreaming sustainability factors into their risk management models and business strategies to reallocate capital away from unsustainable economic activities to more sustainable ones (i.e., from industries heavily reliant on fossil fuels to renewable energy production). Others are incorporating green credit guidelines and other sustainability measures into their business practices. Two areas have emerged: first are 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 in 2003 to provide voluntary guidance on incorporating environmental and social risks into banks’ 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 specialized short-term credit transactions that mobilize more capital for the green economy. Banks are also mainstreaming certain areas of ESG practices into overall bank governance strategy. In this way, they are a crucial source of capital for the emerging green economy.

The costs of taking action are borne in the short run but the benefits accrue to 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 goes way up.

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. 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 accrue to 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 goes way up. Delayed actions to avoid a financial and environmental crisis — or to deal with it once it happens — also become more costly.

Regulation to the Rescue

A few countries have taken steps to incorporate environmental sustainability risks into financial regulation. The European Commission has proposed that the EU incorporate a risk-based sustainability factor into the risk weightings of bank capital regulation. 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 requires 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 harmonized standards.

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 1 — Minimum Capital Requirements, Pillar 2 — Supervisory Review (regulatory) and Pillar 3 — 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 help national regulators work with banks to adopt best practices in the management of financial risks that derive from unsustainable activities, and in the collection and analysis of data to refine the banking sectors’ understanding of what sustainable economic activity is and of how much capital and liquidity banks should hold against environmental systemic risks. For example, the European Commission has published an Action Plan to establish an EU classification system — or taxonomy — for sustainable economic activities so that banks, investors and other market participants can have a shared understanding of what “sustainable” means. The Commission also proposed EU legislation in 2018 that would set out uniform criteria to determine whether economic activity is sustainable or not, and provide a process to involve stakeholders in developing this taxonomy. The taxonomy would provide banks and investment firms with more clarity about whether their lending and investment strategies are oriented toward economic activity that is genuinely contributing to sustainable development objectives.

Regulators can also play an important role under Pillar 2 by requiring banks to conduct stress tests involving scenario analysis that incorporate forward-looking scenarios that estimate the potential financial stability impact of supplying credit to environmentally sustainable or unstainable activities over time.

And under Pillar 3, regulators can require banks to disclose information about how they’re managing the environmental systemic risks they face. Shareholders have used this approach in the U.S. through proposed resolutions that would require a bank’s board to disclose the institution’s exposure to high-carbon activities. However, such resolutions have become increasingly political and the climate change reporting less relevant to average shareholders, because the guidance issued by U.S. bank regulators on disclosing emissions stemming from fossil-fuel-related loans has not led to an increase in the quality or quantity of the disclosures. Thus, a more effective regulatory approach might contain rules on both qualitative disclosures (e.g., based on voluntary codes and industry standards) and quantitative disclosures defined by the financial regulators working with the accounting industry. And it is important that such disclosures are comparable across banks and jurisdictions, which is why the Basel Committee should ensure that regulatory disclosure is standardized across countries.

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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 Congress in the wake of the financial crisis that spurred the Great Recession: “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.”

To be sure, regulatory intervention, if not calibrated properly, can also 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. So, too, is the desire to encourage efficient bank lending and investment in productive activities of the economy. It’s increasingly clear that climate change is changing the calculus of what we consider productive. It’s time for banking regulators to respond.

main topic: Climate Change
related topics: Finance: Banking