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Climate Risk

To Fight Climate Change, Don’t Increase Bank Capital

Society, desperate to reverse the effects of global warming, finds a spare pound coin behind the couch cushions.  This being an abstract thought exercise, we are allowed to consider only three possible options for the bounty.

Two involve investing the money, one in a clean, carbon-reducing endeavour, the other in a dirty, carbon-increasing one.  The third option involves locking the coin, in perpetuity, into a bank vault.

If your sole purpose is to fix the climate, clean investment is obviously the superior choice.  Locking up the funds will have one big advantage – it will block the pound from being ploughed into the dirty investment – but it won’t do anything worthwhile to aid transition to a sustainable economy.

Toyn Hughes headshot
Tony Hughes

This exercise is relevant at present because the Bank of England seems determined to require banks to hold more capital to cover potential climate-related losses.  This will effectively mean that a large number of extra pound coins will soon be sequestered in bank vaults, curtailing investment in both clean and dirty enterprises.

If bank safety is threatened by physical and transition risks associated with climate change, the central bank may, on the face of it, be justified in taking this action.  Given the drawn-out but existential nature of the climate threat, however, a deeper analysis quickly reveals its counterproductivity.

In the majority of situations, credit risk associated with a new bank loan will be realized within months or a few years.  The average tenor of bank exposures is invariably less than 10 years and bad loans tend to default sooner rather than later.  

In the case of climate risk, regulators are asking banks to evaluate scenarios that creep up over many decades.  The European Central Bank’s (ECB) recently released stress test, for example, found that the average corporate loan would see default likelihood increase by 7% by 2050 under the most extreme “hothouse world” scenario relative to the ideal “early action” baseline.  The entirety of the increase in risk was projected to occur after 2030.

Figure 1: Probabilities of Default – Percentage Changes Relative to the Baseline Scenario

Figure 1
Source: ECB Report – Economy-Wide Stress Test (pg. 55). ECB calculations are based on NGFS scenarios (2020), AnaCredit, Orbis, iBACH, Urgentem and Four Twenty Seven data (2018). Notes: Banks are classified as significant institutions (SI) based on the definition set out in the SSM Regulation and SSM Framework Regulation. Median bank refers to the median probability of default per year and scenario of the respective sample.

By this time, the vast majority of loans outstanding in 2021 will have been paid off.  The ECB’s analysis therefore indicates that climate risk will have effectively zero net impact on the current loan cohort and only a slight impact on the next one.  By the ECB’s calculations, there will be a clearer loss potential for the cohort that will be originated around 2040, but a lot of water will flow under the bridge between now and then.  

If a substantial amount of climate-specific capital is set aside right now, banks will effectively be carrying a deadweight for the next decade.  These funds could, in principle, be mandated or otherwise channelled to fund productive carbon-reducing initiatives.

Now suppose that the ECB’s calculations were overly optimistic – assume that the current loan cohort is actually at an elevated risk of loss during the next decade as a result of climate change.  Viewing the problem strictly through the lens of bank safety, an increased capital charge can, under these circumstances, be fully justified.  

The problem is that bank safety is not the sole – or arguably even the most pressing – concern for society at this juncture. It may be sensible for us to accept a slightly elevated risk of a banking crisis in order to slightly improve the odds of successfully addressing the climate crisis.

It’s all a question of degree – literally – and also of timing.

Climate scientists maintain that the next decade will be critical.  In the absence of concerted action, temperature tipping points will soon be tripped, causing irreversible, adverse consequences for the planet and its resident organisms.  

Given this, it seems extremely cavalier to consider diverting resources away from the battle, instead choosing to reserve them for an unlikely climate-triggered banking collapse specifically affecting the current loan cohort.

As many have suggested, fiscal policy, especially a carbon tax, would be a far more effective way for the government to address climate change.   

But given the potential for political inertia, many will argue that central banks should use available levers to do something.  In this sense, capital may be a valid, if suboptimal, way to impose additional cost on banks that are actively funding dirty investments.

Bank-specific charges, however, do not necessarily have to increase the aggregate amount of capital reserved across the industry.  If the Bank of England pursues a climate capital strategy, it should ensure that the overall impact of the intervention is either neutral or slanted slightly in favour of increased green investment.  This could be achieved by rewarding virtuous banks with a negative climate capital charge.

Pound coins in bank vaults, like fallow fields, serve an important purpose in the economy.  To fix climate change, though, central bankers should look elsewhere to find the most effective policy intervention.

Photo by Steve Smith on Unsplash

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