It takes two for Tango – Central banks and commercial banks, partners in managing climate change

There were two fundamentals that I covered in my previous blog Managing climate change – who owns it anyway. The first is the definition of boundaries with clear responsibility/responsibility for the main stakeholders and the second is the need for smooth collaboration between them.

Central banks and commercial banks are the main stakeholders in the banking sector. They need
“work togetherto make the climate change project a success. Although each has its specific areas of influence and responsibility, the policies, approach, direction and actual actions of one have an intrinsic impact on the other. The following stream gives an overview of the symbiotic relationship between the two.

Climate change is a source of financial risk and can lead to different types of risk. The two main ones are physical and transient risks. These affect the economy, and therefore financial systems, in multiple ways** and are therefore of great concern to both.

  1. Disruption of business, destruction of assets (damage to property, infrastructure, land, product), migration, decline in value of “stranded assets”, increase in energy prices with disruption.
  2. These translate into lower property and asset values, lower household wealth, lower corporate profits and more litigation, lower growth and lower productivity, among others.
  3. This affects the financial system through market losses (falling prices of stocks, bonds, etc.), credit losses (actual defaults, deferred payments), operational losses, including liability risks.
  4. The impact indicated in 3 above will have a negative effect on the economy, leading back to point 1, thus forming a vicious circle

**Adapted from IMF Finance & Development, December 2019, Vol 56.

As Frank Elderson, Vice-Chairman of the ECB’s Supervisory Board, has pointed out, “Whatever
combination of physical and transitional risks materialize, the macroeconomic consequences and financial risks resulting from the climate and environmental crisis will be profound. Regulators are rightly concerned about inflation, prices, employment, productivity, the stability of the financial system, and the safety and soundness of the banking sector. Banks are also working on the best ways to support their customers in their transition journeys, while having to manage the potential negative financial impact of the combination of physical and transient risks in their books that could threaten their sustainability and growth.

The big question is how to draw the lines of individual responsibility and accountability while working together to achieve a common goal. There’s a quote I’ve come across, in a few news articles, that points to a potential path of rational delineation
“It’s not our job. We don’t tell banks which sectors to lend to. We ask them to manage the risks and make sure they have good processes in place…” Lael Brainard, member of the Federal Reserve Board. This is an important position from a border management perspective. There are three important themes here.

  • First, regulatory oversight will not include guidelines to banks about which sectors not to do business with. Banks are or are expected to be mature partners in the climate management journey. They are expected to ensure a responsible approach to business in order to be in tune with the environment in which they operate. This position not only empowers banks, but also makes them accountable for their actions and commitments.
  • Second, banks will be asked to manage risk – Managing the potential negative financial impact of climate change risk on their books is rightly in the domain of banks.. Banks are responsible for establishing appropriate risk concepts and ensuring their effective and efficient application. It is in the interest of the banks themselves!!
  • Third, through supervision, regulators will ensure that they have good processes in place – This is where oversight comes in.

The challenge, no doubt, comes from the banks which might either be in the interest of their revenues or to help their customers. try to operate under the radar. Supervisors have tools, instruments, policies and procedures to curb wandering banks that do not align. The effective use of Pillar 2 (prudential supervision) and Pillar 3 (Market information) will be a powerful deterrent. The added benefit of climate change management efforts is the presence of strong and credible global organizations developing well-thought-out disclosure requirements. Examples are the TCFD (Task Force on Climate-related Financial Disclosures) framework for disclosures by banks and its counterpart NGFS (Network for Greening Financial System) “Guide on climate-related disclosures for central banks”. The transparency and detail expected from these disclosures, the scrutiny of active civic bodies, investors/shareholders coupled with strong social media, will make it difficult for errant banks to err above or below the radar!!

In my next blog, I will look an interesting vocabulary in the “green” relevant climate change management space for banks.

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