Story time.
I was a newly minted undergrad back in the late 2000s. I was fresh on the job market after two banking internships bang in the middle of the 2008 financial crisis. Doubling down was the favourite pastime of my younger self (can’t say a lot has changed now). I started at a well-recognised global financial institution after graduation — one that was weirdly proud of its work culture that it advertised that it ‘never sleeps’.
I can speak from first-hand experience that this was indeed true. This was me in my early 20s.
Without insinuating that I had any role to play in this, something significant happened in global banking regulations between the years 2009 and 2011.
Hindsight or nothing
The amazing ability that we call hindsight gave way to ‘stress tests’ for financial institutions — a means to assess capital-levels within banks, and its sufficiency for worst-case scenarios, aka go belly up.
Could it have come a couple of years earlier? Sure. We would certainly appreciate defusing a bomb named ‘too big to fail’ before it detonates.
(This is not a tirade on how humans dig a hole for ourselves, find our way to the bottom of said hole, and then say, ‘at least, we don’t have to suffer through traffic’.)
Climate crisis and retroactive fixes go hand in hand. One such fix came about last week.
Global climate action is borrowing an important tool from global banking regulation — to keep enough piles of cash (capital) in its reserve to account for climate risks.
Existential ‘Stress Tests’
The European Central Bank (ECB) announced earlier this year that it will add climate-change risks to the framework that sets capital requirements for lending institutions, starting with a stress test.
First, a quick explainer. There are two types of climate risks.
There is the physical risk.
Climate change can affect banks via physical events such as floods that wipe out the value of buildings that back mortgages, lower creditworthiness of borrowers in certain cases, and adversely affected asset prices held within the portfolio
Physical risks can lead to →
Business disruption
Heightened levels of operational risks
Damage to physical assets
Failures in the transportation system(s)
Disruption to the supply chain
There is also the transition risk.
Transition risks are those that impact a bank’s existing service offerings, as a result of a shift to a low-carbon or a green economy. These include the extent to which a bank has exposure towards high-polluting sectors, ESG agenda among stakeholders, and any regulatory changes that require sweeping changes to its operations
Transition risks include →
Increased costs due to regulation (e.g., carbon tax), which can significantly alter the underlying economics of the business
Increased costs due to liability claims (e.g., from increased lawsuits)
Reduced demand (e.g., consumer sentiment, investor sentiment)
Risks from advancements in technology
ECB clarified that the 2022 version of the stress test is a ‘learning exercise’ for regulators and the sector alike, and that there will not be any direct implications on additional capital requirements.
The regulator published the aggregate results of the test last week.
European Banks be too blessed to be stressed
$71 billion.
That’s the expected hit to the European banking sector from increasing natural disasters, from the stress tests.
To put that in perspective, the value of total assets held within the European banking sector is ~ $40 trillion.
In other words, climate risk makes a 0.1775% dent on the entirety of the European banking sector. It’s funny when just flood-related losses in 2021 stood at $90 billion.
SwissRe, the largest reinsurer in the world pegged that the global economy stood to lose 18% of its GDP if no action is taken. Yes, it conducted a stress-test too. It’s simple math once you know global GDP stood at ~$142 trillion for the year 2021.
Typically, stress tests model macroeconomic implications of the risks. In this case, it was only limited to the effects climate change will have on the balance sheets of the banks. For a comparable assessment, a stress test on the effects of the pandemic last year set 50 banks back by ~€400 billion.
It’s a little difficult to comprehend what they stood to learn from this “learning exercise” they carried out. In case you are wondering, no, ECB said it won’t break out figures for individual banks.
What stress test?
There’s measuring climate risk …
To measure climate risk, we first need to understand how it is transmitted into the financial system.
Microeconomic → affecting banks and their individual counter-parties, including effects on banks’ ability to fund themselves
Macroeconomic → affecting entire economy’s labour and industrial productivity and economic growth, including effects on banks ability to continue to operate competitively in such environments
The ECB ‘stress test’ significantly fell short on quantifying the macroeconomic transmission of climate risks into the financial system. Deficiencies and data gaps can only result in flawed results.
And quantifying is supposed to be the easy part.
… and then there’s managing climate risk
You can measure all you want. Managing climate risk is the holy grail.
While the outcome of the ECB ‘stress test’ is to have higher capital reserves to counter climate risk, the more durable results will occur through changes in how banks conduct business in a warming world.
There’s not a lot of good news here.
Banks and lenders are using the lukewarm results from the stress test to lobby against efforts to cover climate risks. According to the ECB, about 60% of the banks don’t have stress-testing frameworks for climate risk, and most don’t include it into their credit risk models. Only 1 in 5 lenders consider climate risk when granting loans.
Of course, the Russian War does not help with any progressive transition. With the EU prioritising energy security, banks continue to help governments seek newer sources of fossil fuels.
Underscoring the banks’ dependence on polluting clients, the ECB found that almost two-thirds of their interest income from companies stems from those that are part of greenhouse gas-intensive industries. Higher-emitting sectors accounted for 21%.
Bloomberg Green (soft paywall)
Climate risk is certainly pervasive beyond the portfolios of financial institutions. And it is important that the financial system understands it. With that said, it might be a tall order to expect an industry built on privatising profits and socialising losses, to lead the fight against climate change.
That is where the regulators have an important role to play.
Frank Elderson, an Executive Board Member at ECB, seems to suggest they are on top of things.
“This is not the endgame. The endgame is that we will treat climate-related risks just like any other risk in our supervisory framework.” […] “It takes time for everyone to get up to speed,”
First things first, Frank. Using ‘endgame’ here isn’t a sound choice at all. Come on, Frank.
But more importantly, merely setting aside additional capital reserves isn’t going to cut it. Sure, that is taking away funds that the banks can lend, but it isn’t a strong enough deterrent.
I know my libertarian friends would roll their eyes at this, but we need better regulation when it comes to flow of credit to polluting entities and sector.
Banks must comply with the pathway that will keep temperature increase at 1.5 degrees, and this alignment should reflect in the way banks run their business.
Regulators can introduce measures to monitor portfolio-level emissions, and introduce provisions that help banks and other financial institutions manage the transition of the high-emitters within their portfolio.
Banks shouldn’t have a problem with this. Especially, since a bunch of them with nearly $66 trillion in assets have committed to achieving net-zero by the year 2030. (So cute!)
Here’s a short 34-second video where banks pat their backs for it. Yup, they haven’t even done it yet.
Happy weekend, y’all.
Before you go, check out the video below. You know it’s only funny because it’s true.