Should Banks Be Forced to Price In Climate Change?

Since the 2008 financial crisis, regulators each year have required big banks to prove they could keep lending through new calamities. The rules, so far, have focused on purely economic disasters: Do they have enough capital to keep their doors open when markets collapse, or if unemployment explodes?

But there’s another kind of risk that didn’t burst onto the radar during that crisis but could trigger just as much of an economic disaster: climate change.

With increasingly severe storms, floods and fires, many forecasters envision a crisis that pivots from the physical to the economic. Imagine back-to-back wildfires and floods devastating huge swaths of California, or an epic drought coupled with tornadoes in Oklahoma during an oil price dip. The growing fear is that widespread damage to property serving as collateral for loans and to assets underpinning other investments could cause devastating financial blowback to banks, not to mention insurers on the hook for the damage.

And as governments try to ratchet down carbon output, it could also threaten banks through their exposure to fossil fuel investments. Some see the global economy’s potential next "Minsky moment"—a reference to the economist Hyman Minsky, who warned of speculative business cycles that end in destabilizing crisis.

What to do about the problem is emerging as a high-level conversation among global bankers, their regulators and an increasingly influential coalition of Wall Street watchdogs and environmental advocates who are winning over a growing number of U.S. lawmakers.

Should banks be subject to a stress test for climate—and if yes, what would it look like?

Stress tests are just one of the tools advocates want regulators to deploy to avert a disaster. But already the conversation is split between different approaches. One prevailing idea is to require more corporate disclosure of climate change risks. Others see the potential need for stricter regulatory intervention — such as an overhaul of bank capital rules — to nudge financial institutions toward a greener economy. 

“I’m not looking at this as a social policy,” said Sarah Bloom Raskin, a former Federal Reserve governor and deputy Treasury secretary who is widely seen as a contender for Fed chairman or Treasury secretary for the next Democratic president. “I’m looking at this as economic resilience and financial institution resilience. I see it as integral to how we actually manage risk.”

The second category is less extreme and dramatic, but may have bigger long-term consequences. Those are the transition risks — the costs incurred as the world, as expected, reduces its carbon footprint to mitigate global warming. 

The concern is that it could trigger its own kind of shock — making financial institutions’ oil and gas investments worthless as carbon-producing energy sources become “stranded” and unburnable.

According to the Rainforest Action Network, 35 of the world’s biggest banks provided $735.6 billion in financing to fossil fuel companies in 2019. One calculation from February by Financial Times Lex Research Editor Alan Livsey put a $900 billion price tag on the value of fossil fuel assets that would be lost if governments tried to limit the increase in temperatures to 1.5 degrees Celsius above pre-industrial levels. Other estimates have put the degree of economic risk in the trillions of dollars.

Many economists have long suspected that climate risks are an underanalyzed, underappreciated threat to the world economy. In a study released in May, then International Monetary Fund found that global stock markets aren’t reflecting the physical dangers of natural disasters. IMF officials said that a first step should be more transparency: "granular, firm-specific information" on climate change exposure, wrote the IMF’s Felix Suntheim and Jérôme Vandenbussche, would help lenders, insurers and investors better understand the liabilities. The IMF said climate change stress testing and scenario analysis for financial firms “can play a potentially important role in providing a better sense of the size of the exposures at a highly granular level.”

The development and enforcement of the recommendations would fall to national regulators, including central banks. Some have already started to move in this direction.

Before Bank of England Governor Mark Carney stepped down in March, he pioneered an effort to begin stress testing banks for climate factors. (He’s since been appointed United Nations special envoy for climate action and finance.) The Bank of England, European Central Bank and Bank of Japan are among the more than 60 central banks and regulators that have formed the so-called Network for Greening the Financial System to collaborate on the issue. In June, the group released a set of climate scenarios as a starting point for analyzing the risks and a guide for regulators with practical advice on how they should proceed.

 

In the U.S., bank regulation falls to the Federal Reserve, Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and state agencies. Among them, the New York Department of Financial Services is the only U.S. representative in the Network for Greening the Financial System.  

Federal Reserve Chairman Jerome Powell, first nominated by President Barack Obama to serve at the the Fed in 2011 and then confirmed as chair under President Donald Trump in 2018, said in January that a systemwide risk to financial stability from climate change is “certainly possible” over the longer term. He indicated that the central bank would take a cautious approach.

“We are in the very early stages, as are other central banks, in understanding just what that means,” he said. “And there’s quite a lot of work going on around the world at other central banks and at the Fed, too, to think that through.”

He signaled that the Fed should play a limited role in the broader policy response to climate: “Society’s overall response to climate change needs to be decided by elected officials and not by the Fed.”

Now, environmental activists, financial reformers and a growing number of influential Democratic policymakers are calling on the Fed and other U.S. regulators to act more aggressively.

One of them is Raskin, a former Obama Fed and Treasury official who has emerged as one of the leading voices on the issue. She said her two former agencies "have to get caught up with the rest of the world." Raskin, who is allied with progressives and is seen as a potential top economic appointee in a potential Biden administration, giving her views extra weight.

"The other central banks are all on this," Raskin said. "They completely understand that climate change is a potential exogenous shock that needs to be prepared for."

Raskin takes a broad view of how the government should get involved. She argues that a Treasury official should be tasked with bringing together financial regulatory agencies to articulate what the problems look like from the position of the firms they oversee. Raskin served a similar role coordinating the Obama administration's response to cybersecurity threats in the financial industry.

"There needs to be a concerted effort first of all within each regulatory agency but then cohesively around what are the real risks," she said. "You can come up with a list of priorities. Maybe that will involve a climate stress test. Maybe it will involve better disclosures around a firm's market valuation that have to do with what their exposure to carbon-based assets is. Maybe firms just need to have plans regarding transitioning away from carbon-based assets."

At the modest end, policymakers around the world have called on corporations to step up disclosures of risks they face from global warming. Beyond that, Democratic lawmakers and activists want the Fed to formally include climate in its bank stress test calculations, forcing lenders to be transparent about their assets at risk. At the more ambitious end, some European and U.K. officials have discussed adjusting rules governing bank capital — the financial buffer to protect against losses — to incentivize “green” investments while penalizing more environmentally harmful “brown” activities. Advocates in the U.S. have said it’s also an idea worth exploring.

Underlying the proposals is a belief that the tools could also hasten the transition to a greener economy — a goal that supporters do not hide. That has banks distressed about whether they’ll become a tool for climate change policy.

In the U.S., stress testing by the Fed has a direct impact on how banks must manage their balance sheets, and bank representatives argue the risks of climate change extend far beyond their current financial exposure. 

Tinkering with how much capital they have to hold based on what’s more environmentally friendly is even more horrific to lenders who say it’s as a way for governments to use bank deposits instead of taxpayer money to fund climate policy decisions. 

“Capital requirements, including risk-weighted requirements and stress tests, should be based on actual financial risk and not co-opted as a subsidy or penalty to serve other public policy goals, however worthy," said Greg Baer, who represents the largest U.S. lenders as president and CEO of the Bank Policy Institute. "Climate change policy should be effectuated through fiscal policy and direct regulation, while financial regulation should remain focused on protecting taxpayers and reducing systemic risk."

The issue has become a political sweet spot for Democrats who want to talk about greening the economy and policing Wall Street excess.

"The failure of our regulators to accurately and thoroughly account for that risk is growing more serious by the day," said Sen. Brian Schatz, a Hawaii Democrat on the Senate Banking Committee who has drafted climate stress test legislation. "They don't have to have an opinion about climate change as a public policy matter. But risk is risk."

In the U.S., where lobbies exert large influence on the agencies that regulate them, what happens will likely need to involve the banks themselves.

While the finance industry is uneasy with the idea of climate stress tests and changes to capital rules, it’s started to show some willingness to put potential threats under a microscope as political pressure has grown. JPMorgan Chase and Bank of America are among the supporters of the Task Force on Climate-Related Financial Disclosures, a G-20-organized group chaired by Michael Bloomberg that is developing voluntary climate-related financial disclosures.

With a range of rules and regulations looming, some of the industry’s biggest players are calling for greater international coordination on what the next steps will be.

"Our members have been on the record and very consistent in saying, these risks need to be identified, they need to be managed," said Andrés Portilla, head of regulatory affairs at the Institute of International Finance, which represents global banks and insurers.

But there are limits. "Whether the regulatory approach needs to be a prescriptive one, or one that leads to capital charges, then it's a different question,” Portilla added.

With U.S. regulators focused on the emergency response to the pandemic, nothing major is likely to happen in the near future, and Trump’s appointees have not signaled that it’s a priority. So climate-related financial risk is shaping up to be another issue on the ballot in November — whether voters are tracking it or not.

The debate that’s just beginning to ramp up will likely leave a mark on the economic policies of the Democratic Party, including presumptive Democratic nominee Joe Biden’s presidential agenda.

 

 “A lot of what we have tried to do and are going to continue to try to do is set the stage for action under a future administration,” said Gregg Gelzinis, senior policy analyst for economic policy at the Center for American Progress. “The first time we progressives think about this issue and think about some of the policy details shouldn’t be the first day controlling the levers of power.”

 

Graham Steele, a former senior aide to Senate Banking Committee Democrats, who now oversees the Corporations and Society Initiative at the Stanford Graduate School of Business, has written a paper that reads like a road map for the next administration, outlining the potential risks and the options available to regulators.

“All these ways in which climate scientists talk about how risk in one region can lead to a tipping point that impacts a different region is deeply analogous to how we think about things like fire sales and run risks,” he said. “It felt sometimes they were using literally the exact same terminology we use when we think about financial regulation.”

It will be a litmus test on the left for Biden's executive appointments, if he wins in November. Elected Democrats including Schatz are already calling on Biden and his advisers to act.

"What I'm hopeful of — and have certainly had conversations about this with all the presidential candidates including now our nominee — is this is not just a question of do they prioritize these issues," said Rep. Sean Casten (D-Ill.), who is sponsoring bills on climate stress tests and climate risk disclosure for corporations. "But do they structure their administration in a way that ensures there's a single point of control to make sure we factor all these things in."