Picture: 123RF/TSUNG-LIN WU
Picture: 123RF/TSUNG-LIN WU

Stockholm — It’s increasingly likely that banks will face new capital requirements to reflect how exposed their loan books are to climate change.

“That is the logical next step,” Janine Dow, a senior director for sustainable finance at Fitch Ratings, said. “Because once you size a problem, then you identify the risk. And as a regulator, you can’t just leave an emerging risk exposed.”

Such a requirement would mark a significant expansion of new rules the financial industry, particularly in Europe, now faces amid a race against time to prevent an environmental catastrophe. The goal is to force banks to channel money away from those corners of the economy that pollute and towards businesses that have committed to lower carbon emissions.

For now, banks remain a long way off that goal. Since the Paris Climate Agreement was struck in 2015, lenders globally have poured more than $3.6-trillion into fossil-fuel financing, according to data compiled by Bloomberg. Only this year has green bond and loan financing taken the lead.

The data

According to Fitch, the financial industry is well aware that bank capital requirements will soon reflect climate risk, even though regulators themselves haven’t yet spelled out their intentions.

“Regulators haven’t been more explicit yet because they don’t have the data to justify a clear approach,” said Monsur Hussain, a senior director for financial institutions at Fitch.

But “if you read between the lines” of the European Central Bank’s (ECB) November guidelines on climate-related and environmental risks for banks, “that is the direction of travel”, he said.

In the guidelines, the ECB instructs banks to consider their sensitivity to climate risk when weighing how much capital they need beyond minimum requirements; with this pillar 2 exercise, mandatory requirements have “already made landfall”, Hussain said.

“The only question is how long it will take to make landfall on pillar 1,” which represent banks’ minimum requirements and is “the key metric by which regulators decide whether a bank lives or dies”, Hussain said. “That’s really where I think the rubber will hit the road.”

“In terms of how far we’re away from that pillar 1 designation, I think we’re still about three years away.”

Cautious watchdogs

The key hurdle now is ensuring that banks get the data they need from companies to enable them to assess their climate risks. And that’s where even regulators are sounding the alarm.

“The issue that concerns me most right now is whether the non-financial sector is capable of delivering the information to the financial sector that the financial sector demands, and which it will have to get, given the whole disclosure and taxonomy apparatus being implemented,” Jesper Berg, the director-general of the Danish Financial Supervisory Authority, said.

As the top financial supervisor in a country ranked the world’s greenest, Berg notes that even in Denmark corporations face a huge task. He also says requirements for corporations to provide data have lagged behind disclosure demands being made on banks.

“As a public authority, we need to flag this issue and the risks so that companies know they need to do something, possibly at an earlier stage than they expected to,” Berg said. “This is not a small challenge for the private, non-financial sector.”

Meanwhile, European banks are being warned by their watchdogs to stop resisting new rules or risk weakening the financial system, as the Basel 3 framework is finalised.

Dow says regulators and lawmakers have so far only indirectly addressed the issue of whether banks should have buffers to absorb potential losses from climate catastrophes.

“If we think of classifications and even stress testing for climate change, none of the regulators have said that the output is going to directly help inform capital requirements,” she said. Still, “we think that, increasingly, regulators are looking at capital requirements on this, taking this holistic approach”,

Bloomberg News. More stories like this are available on Bloomberg.com

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