Climate change risk and the banking sector
In August 2020 the ECB published its latest internal capital adequacy assessment process. With respect to climate change risks the reports indicates that the banks’ practices for considering these in their risk management processes is characterized by:
- Limited reliance on climate-related indicators as part of a broader sustainable finance strategy;
- Bundling of climate-related risks with other risks, with “environmental and social risk” and “sustainability risk” being the most common categories. Only a few banks treat climate-related risk as a separate risk category.
- Lack of established internal processes that allow them to systematically identify and manage climate-related risks. Therefore, these banks continue to take uninformed business decisions that expose them to risks that could have material negative consequences for capital adequacy in the medium to long term.
What type of regulation is necessary?
[T]here is an urgent need for policymakers and investors to approach transition risks with caution. Financial policymakers must work with the assumption that financial markets underestimate transition risks. Concretely, this implies adding a precautionary margin to the risk metrics used by financial markets, to reflect possible transition risks that are unaccounted for.Financial supervisors should integrate this precautionary principle in prudential regulation. Loans to firms exposed to high transition risks are – by definition – riskier than others. This should be reflected in microprudential regulation with higher capital requirements for loans to such firms. At the macroprudential level, financial regulators should also add precautionary capital buffers when significant parts of the banking sector are engaged in loans to firms exposed to transition risks. These measures would strengthen the banking sector in case of a crisis, as well as incentivize banks to lend to firms who are building up resilience to pandemic and environmental crises.
The role of central banks
In a recent speech Isabel Schnabel wondered whether the ECB should be more proactive and forceful in greening its asset purchases. For example, should QE asset purchases focus on securities issued by firms that are able to fully assess climate-related risks?
[T]here are two opposing views regarding the debate on greening asset purchases.
One view is that central banks would overstep their mandate if they were to discriminate among investors on the basis of considerations that fall into the realm of fiscal policy. According to this view, market neutrality is the benchmark central banks should use when purchasing bonds issued by corporates.
The other view is that central banks have to respond to market failures and incorporate the far-reaching risks that climate change poses to price stability when designing their policy instruments.
Never waste a crisis: COVID-19, climate change and monetary policy
By: Isabel Schnabel – ECB