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Central banks understand the systemic risk climate change represents, and they are starting to take action.

Now, more than ever, central banks are focused on risk. As COVID-19 evolves, they are increasingly recognizing that the rebuilding phase offers a unique opportunity to encourage action on the climate change agenda. Here’s what bank executives should know.

While the acute phase of COVID-19 may have drawn central banks’ attention away from the environmental, social and governance (ESG) agenda as they dealt with the immediate economic challenges, all signs suggest that focus is quickly returning.

What the central banks are starting to recognize is that the COVID-19 health and economic situation has created a unique opportunity to deal with a different, much slower-moving, yet equally disruptive systemic financial risk caused by climate change. Central bank leaders have been raising the alarm for years.

“As financial policymakers and prudential supervisors we cannot ignore the obvious physical risks before our eyes," warned Mark Carney, former Governor of the Bank of England and François Villeroy de Galhau, Governor of the Banque de France, last year. "Climate change is a global problem, which requires global solutions, in which the whole financial sector has a central role to play1.”

Those familiar with Mr. Carney would not have been surprised. As the head of the Bank of England, he had been sounding warnings about the systemic risks of climate change for years. The stark message to the financial sector came as part of a report from the Network for Greening the Financial System (NGFS) outlining steps that central banks should be taking to help combat climate change2.

Now, as public and private funds start to flow towards rebuilding the economy and restarting industries, the pressure is rising. Investment capital is rapidly moving towards ESG-linked and impact investment vehicles. At the same time, society’s expectations and common values are shifting; in the wake of the COVID-19 situation, people care more about ESG and climate change than ever before. The reputational risks of inaction are growing.

Not surprisingly, central banks now recognize that the markets are evolving quickly. They know they need to catch up if they want to ensure they are able to shape the systemic risk of a climate crisis3.

Taking action

So what are the central banks and banking supervisors doing to help transition the industry towards a greener future? Prior to COVID-19, some central banks had been surprisingly active. The EU is, perhaps at the forefront. On 23 April (in the midst of the COVID-19 situation) the European supervisory authorities published their draft regulatory technical standards related to ESG disclosures4.

The European Central Bank (ECB) has also been moving on a number of fronts. Before COVID-19, they had been hard at work helping the EU Commission develop a European-wide taxonomy to be used in climate-related information disclosures. A taxonomy should help bring a level of consistency and awareness to the industry (in Europe, at least) while clarifying which economic activity can be viewed as being environmentally sustainable.

They had also been working closely with technical expert groups on sustainable finance, green bonds and other emerging areas related to the climate change agenda. They had started talking to their banks about their level of preparedness for dealing with the risks associated with climate change.

At the national level, central banks are also making strong intonations about their expectations for their respective banking industries when it comes to managing climate-related risks. Last year, for example, the Bank of Spain held a number of meetings with industry in which they have clearly communicated they will be taking a close look at their banks’ risk functions to assess their ability to understand, mitigate and measure these new risks.

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A coordinated effort

A growing number of central banks and banking supervisors are starting to work together to progress a global approach and agenda. The Network for Greening the Financial System (the group that issued the report forwarded by Mr. Carney and Mr. Villeroy de Galhau) is, itself, a global network of central banks and banking supervisors. In the 2 years since its founding, it has already grown to include 55 central bank members and 12 observers.

The Bank for International Settlements (BIS) — an institution owned by the central banks — also plays a global financial regulatory role and has weighed in with a recent report that looks at the systemic financial risk posed by climate change and offers some potential policy responses that could be brought to bear by central banks5.

Other initiatives have also helped influence the agenda for central banks and their industry constituents. The Task Force on Climate-Related Financial Disclosures (TCFD), for example, was created by the Financial Stability Board (FSB) and included leading industry executives, thought leaders, accounting firms including KPMG and academics from around the world. That group created a set of recommendations aimed at developing a structure for disclosing information on climate-related risks and opportunities6.

The pressure is rising as more investment capital starts to flow towards ESG-linked and impact investment vehicles.

More regulation, please!

Clearly, the ongoing COVID-19 situation will slow government action in translating this thought leadership and activity into actual regulations, supervisory expectations and guidance that banks can apply to their current risk and control frameworks. For once, banks seem to be asking their supervisors for more rigor and regulation.

That won’t likely come any time soon. Notwithstanding their work on taxonomy, disclosures and the green bond market, the EU is still some way off from promulgating formal regulation on the topic. That being said, the ECB is starting to include climate considerations in their current monetary policy review (“We are not sitting on our bottoms doing nothing,” noted ECB head Christine Lagarde at a recent news conference).7 Other major markets seem to be stopping short of translating their ‘expectations’ into actual guidance.

Instead, the central banks and banking supervisors seem to be focused on encouraging the banks to have the right data, the right risk management approach and the right transition planning capabilities to ensure resilience in the face of various climate risk scenarios. They are helping banks understand what the leading organizations are doing. They are offering tools and structures to help banks improve their ability to measure, manage and mitigate the associated risks.

What does this mean for banks?

Perhaps the biggest takeaway for banks should be that the financial system regulators and authorities are all moving in one direction on the ESG agenda. Rather than dampen focus on the long-term climate change risk COVID-19 has sharpened it. Banks will want to achieve a clear understanding of how their particular regulators and authorities plan to achieve their agenda over the medium-to-long term. 

It’s not just the financial system regulators and authorities banks will need to monitor and understand. Many banking customers — not only in the extractive industries — will soon need to comply with more stringent ESG requirements, too. And that could add significant risk to a bank’s portfolio. Understanding the ‘downstream’ impacts will be a significant and important undertaking.

If they haven’t already done so, banks should also be taking the time to assess their preparedness for some of the risks outlined by the BIS and the NGFS in their recent reports. There are a number of organizations working to develop scenario analysis guidance (the NGFS is one group spearheading that workstream) that should help banks start to think through all of the various potential outcomes and impacts.

At the same time, banks should also be examining their data, their risk processes and their capital allocations — post COIVD-19 — to understand exactly how they are currently managing these risks. Looking forward, they should be considering how to include climate considerations into their target operating models into their strategies and new operating models as they rebuild their books of business.

Banks could also be working closely with their central banks and supervisors to help shape the agenda and drive positive action. Whether through participation in regulatory task forces or simply through industry association activity, banks should be working with the regulators and supervisors to drive towards a comprehensive solution.

Central banks and banking supervisors understand that COVID-19 is going to cause deep economic challenges. And their priority today is (rightly) to manage those risks.

Yet disruption always brings opportunity. This crisis will be no different. At the very least, the COVID-19 experience will change the way communities view sustainability. And that, in turn, will create unique opportunities to mitigate the longer-term systemic risks created by climate change.

While progress may have been slowed in the short-term, there is every indication that the central banks now have every intention of getting ahead of the curve. Banks had better get ready.

Footnotes

  1. The financial sector must be at the heart of tackling climate change
  2. NGFS first comprehensive report (PDF 2.6 MB)
  3. Joint consultation paper (PDF 911 KB)
  4. BIS (PDF 3.7 MB)
  5. BIS (PDF 3.7 MB)
  6. Task force on climate related Financial disclosures
  7. Climate Change Could Blow Up the Economy. Banks Aren’t Ready