Introduction
Yesterday’s release of the FSOC Report on Climate-Related Financial Risk clearly demonstrates increased attention by policymakers and the public on the potential impact that climate change may have on the financial system. By climate change, we mean long-run changes in our climate that are expected to unfold over several decades. Large financial institutions have already taken a number of important steps to identify, assess, and manage climate-related financial risk. When we think about how climate change may inform large bank regulation, we must be thoughtful about the challenges presented by climate change, the risks that capital are intended to address, and measures institutions and regulators are already taking to address the complexities of climate change. In this post, we discuss climate change and its relation to large bank capital and risk-management policies. As in the FSOC report, we find that a focus on risk management, including scenario analysis, is important to address climate-related financial risk.
Climate Change, Risk Management and Large Bank Capital
A key characteristic of climate change is its long horizon. The effects of climate change are expected to unfold over decades, and not months. Capital requirements are keyed to a much shorter horizon, such as a few months or quarters. The reason for this short-term horizon goes to the central purpose of capital. Capital is a financial resource contributed by shareholders that is intended to absorb losses in the short-term that can’t otherwise be mitigated through risk-management actions. In this sense, risk management is the “first line of defense,” while capital is the “last line of defense.” When dealing with long-term trends, banks regularly engage in a number of risk-management activities that change and improve their economic risk exposures long before capital would be needed.
For example, if banks perceive a rising risk of flooding over the next 25 years from rising coastal sea levels, they can incorporate those views directly into their lending decisions. This proactive risk management is forward-looking and comes well before any build-up of risk. Moreover, this risk-management activity effectively responds to emerging climate trends to efficiently reallocate resources from those industries and assets that are expected to be most affected by climate change. The long-run nature of climate change strongly suggests that risk-management policy should be proactively applied over time to ensure bank safety and soundness while also ensuring an agile economy that responds to the market signals presented by a changing climate.
Some have argued that capital policy should be recalibrated to address climate change because higher capital requirements will disincentivize certain activities that may contribute to climate change. It is certainly true that higher capital requirements increase the cost of financing and disincentivize investment. At the same time, it is critical to recognize that the primary purpose of capital requirements is to ensure a safe and sound banking system by guarding against short-run economic shocks that can’t be predicted. Capital requirements that are designed to incentivize economic behavior risk reducing the effectiveness of capital as a tool to support bank safety and financial stability. In addition, it is important to note that predicting how climate change will impact different parts of the economy is extremely difficult given all of the uncertainties and connections between different sectors, industries and climate policy. Accordingly, using capital requirements to influence investment decisions risks creating the wrong incentives that would impede the most productive means of dealing with climate change.
Finally, two potential consequences of using capital requirements to deal with climate change should be considered. First, increasing the cost of credit to certain industries may frustrate their ability to invest in emerging technologies needed to address climate change. Second, disincentivizing certain activities through bank capital requirements may simply push those activities outside of the regulated banking sector, which may have broader financial stability effects while not influencing the overall level of activity.
Climate Change and Stress Testing
Some have also suggested that climate change be incorporated into bank stress tests that assess large bank resiliency over a nine-quarter horizon. As discussed, the long horizon associated with climate change simply does not line up with the relatively short horizon of the stress tests. Also, stress tests are currently implemented by assuming that balance sheet composition is fixed and unchanging. In the case of climate change, this assumption would be violated as banks’ risk-management assessments will lead them to adjust their business models to account for the long-run challenges of climate change.
Further, unlike more traditional capital requirements, the stress tests are designed to assess bank resiliency in a period of financial and macroeconomic stress. It is altogether unclear that a period of short-term macroeconomic stress would coincide with a period of climactic stress. Climate change’s lack of any clear association with relatively short-term macroeconomic stress makes its inclusion into the stress tests even more problematic.
Climate Change and Risk Management
If capital requirements and stress testing are not natural policy levers for addressing climate change, then what policies can be effective? Ongoing and active risk management by large banks is a critical tool for addressing climate change. Climate change and the associated government policy response may well have wide-ranging economic ramifications over the long run. As banks assess these impacts on the economy, they will make decisions about resource allocation and business lines that directly respond to fundamental economic signals – such as the economic signal sent by a carbon tax.
One tool that has been discussed in this context is scenario analysis. Scenario analysis maps out the potential impact of long-run climactic change – such as a rise in coastal sea levels – and then assesses a bank’s exposure to that change. Scenario analysis is a useful tool in this regard for two reasons. First, such analyses are, by design, exploratory as it is hard to predict what will occur over long periods of time. Scenario analyses allows for considerable flexibility in measuring the impact of climate change and recognizes the uncertain nature of the exercise. In particular, scenario analysis can be flexibly targeted to the specific assets and exposures of an individual bank in a way that would not be possible with a standardized climate scenario. Second, scenario analyses can be useful for identifying those businesses, assets and practices that may need to change over the long run. As experience with scenario analyses builds, and data on climate change unfold, banks can take concrete risk-management steps that align with the economic realities they face.
Conclusion
A changing climate presents a number of important issues for our environment and society over a long period of time. As we deal with these challenges, it is important to keep the appropriate role of risk management and bank capital requirements in perspective. As the first line of defense, risk management has a natural role to play in the long-term management of climate-related challenges. In light of the long-run nature of climate change, capital and stress testing policy is less likely to be the most appropriate policy tool for addressing climate change. Using capital requirements to address climate change risks reducing the effectiveness of capital as a safety and soundness tool, reducing the availability of finance to those sectors that will need to address climate-related challenges, and may push important activities outside the regulated banking sector. Ultimately, addressing climate change will require a persistent, economy-wide effort that involves all sectors to ensure that we address climate change in a way that is effective and inclusive without leaving any segment of the economy behind.
Read the Forum’s statement following the release of the Financial Stability Oversight Council’s (FSOC) report on climate-related financial risks and financial stability here.