“Basel V” Should Target the “Green Swan”

Courtesy of Mete Feridun

Recently, the Bank for International Settlements (BIS) coined the term “green swan” to refer to the tail risks posed by climate change to financial stability. Although inspired by Nassim Nicholas Taleb’s “black swan,” the moniker of unexpected risks, the BIS argues that the green swan is hardly similar to the black swan, as the occurrence of climate-related shocks is inevitable. The BIS stresses that scientific research has already ascertained the occurrence of green swans, and warns that the magnitude of financial risks posed by climate change is unprecedented.

Background

Climate change is already transforming banking and banking supervision in some countries, as the industry begins to recognize climate-related events as a severe financial risk. It is becoming increasingly fundamental for the banking sector to understand, identify, and address climate-related financial risks. Broadly speaking, climate change translates into financial risks via physical and transition channels.

Physical risks include extreme heatwaves, rises in seawater levels, mega-fires, and floods, which may impact creditworthiness and asset valuation. For instance, rising sea levels threaten coastal property values, whereas persistent drought conditions pose risks to agricultural loan portfolios. On the other hand, transition risks, arising from a shift to clean energy, pose a serious threat to banks that have loaned and invested heavily in oil and gas companies and could face losses once those industries become less viable in a lower-carbon economy.

The urgent need to safeguard the financial system against these risks is undeniable. A few central banks and financial regulators across the world have already recognized climate-related events as a severe source of price and financial stability risk and have started taking action to address them. However, given the intrinsic complexity of climate change, a concerted global strategy across all financial regulators and central banks is needed.

The Green Swan

The BIS explains that climate-related risks are “transmitted through complex and inter-connected channels” and have “cascade effects.” They are also “propagated non-linearly with destructive feedback loops” and can “cascade across sectors, countries and systems” in a chain reaction. As the BIS cautions, taking no action against climate-related risks may result in the climate-related shocks becoming more frequent and severe (i.e., higher physical risks), but taking inappropriate and sudden action may cause cliff effects and fluctuations in asset prices (i.e., greater transition risks). The BIS further argues that while there is no silver bullet to mitigate climate-related risks, uncoordinated action from national regulators could have unintended consequences.

In an example of coordinated action, the Bank of England has taken the global lead in identifying climate-risks and integrating them into prudential regulation and stress testing. The regulator plans to stress test banks under its , which will constitute the first comprehensive assessment of the UK financial system’s exposure to climate-related risks. It plans to use certain variables concerning rising temperatures, weather variability, and sea-level rise to assess the resilience of the business models of financial institutions, and the broader financial system, to the physical and transition risks of climate change. The Bank of Canada has also recently published a Climate Change Scenario Analysis study.

In contrast, other national financial regulators are still dragging their feet when it comes to incorporating climate change into their mandate. In the US, the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation do not require climate-related stress tests. Thus, more work is needed to encourage national regulators to factor climate-related risk into banking supervision.

Basel Committee on Banking Supervision’s Response to Climate-Related Risk

A recent survey by the Basel Committee on Banking Supervision (“the Basel Committee” or “the Committee”) reveals that the majority of the members consider it appropriate to address climate-related risks within their existing regulatory framework. The findings are encouraging, with 89% already having researched climate risks and 81% having published supervisory guidance on them. A small number of financial regulators have already required the banks they supervise to stress test their loan and investment portfolios for any risks associated with climate change, and some global banking groups have started considering weather events in their internal risk management frameworks.

The Basel Committee has established a high-level Task Force on Climate-Related Financial Risks (TFCR), with a mandate to develop analytical reports on measurement and transmission channels and identify effective supervisory practices to mitigate such risks. Nevertheless, there is scope to do much more than conducting surveys to address financial stability implications for the global banking system.

For instance, other supra-national bodies have already been more vocal and active with respect to financial risks from climate change. The Task Force on Climate-Related Financial Disclosures (TCFD), established by the Financial Stability Board, has recommended applying scenario analysis, i.e., examining risks in loan books under various warming scenarios. Likewise, the Network for Greening the Financial System has urged central banks and supervisors to incorporate climate risk into their evaluations of both the broader financial system and individual banks. More recently, the International Monetary Fund has also expressed its plans to contribute to the understanding of the macro-financial transmission of climate risks by improving its stress tests within its Financial Sector Assessment Program.

In Europe, the European Central Bank has initiated the development of an analytical framework to carry out a “climate risk stress test analysis” for the euro area banking sector. It has also recently published its supervisory expectations with respect to climate-related and environmental risks. In addition, the European Banking Authority’s 2019 Action Plan on Sustainable Finance has outlined its approach and timeline for delivering mandates covering key metrics, risk management, scenario analysis, and adjustments to risk weights. Rather than waiting for the final rules, the regulator has explicitly required banks to start acting on climate-related risks.

Meanwhile, the Basel Committee, prioritizing shorter-term, more immediate issues, such as Basel III and “Basel IV” implementation, has perhaps been late to respond to climate change risks. So far, the Committee has only reviewed the individual requirements set by its member jurisdictions, identifying a few critical supervisory expectations on climate-related financial risks, such as outlining supervisory plans and activities, taking actions in governance, risk management and disclosure of climate-related exposures, providing guidance on how to integrate climate-related financial risks within risk management, and requiring banks to increase credit availability to green and low carbon sectors. Additionally, while there is an ongoing global initiative to encourage public disclosure of climate-related financial risks under the Basel III Pillar 3 framework, the Basel Committee has not published any standards for these risks.

Conclusion

Climate risks pose unique challenges to financial regulators as they have distinctive characteristics separating them from other types of financial stability risks. The identification, assessment, and management of climate risks require more holistic, strategic, and concerted efforts from the central banks, regulators, and financial institutions across the globe.

Therefore, the Basel Committee should take the global lead on establishing a universal set of standards and guidelines, as well as a supervisor mechanism to mitigate the risks and their regulatory treatment. This also requires the Basel Committee to encourage banks to stress test for climate risk and provide specific and consistent guidelines in this regard. The Committee should also consider introducing “Basel V,” a new package of capital standards that: (1) provide specific risk weights for exposures to climate risks and carbon risk industries, (2) require banks to hold more assets to cover related risks, and (3) discourage banks from lending to those industries. Waiting too long to address the green swan could result in severe financial risks further crystallizing within the global banking sector.

Leave a Reply

Leave a Reply

Your email address will not be published. Required fields are marked *