Central banks have an important role to play in protecting our financial systems. As the guardians of monetary policy and supervisory practices in their respective nations, they need to fortify our economic systems against the ever-growing threat of climate risk. After all, we know more about the risks that the climate crisis is creating within our economies than we knew about the subprime loan crisis that nearly crippled the financial system in 2008.
Climate change is not only limited to the physical threats of increasing temperatures, rising sea levels and intensifying storm systems that are already impacting our planet and our people. It also presents a growing risk to our financial markets and institutions. This is not a problem that a business-as-usual approach can solve.
If a banker or a bank regulator suggested they did not need to plan for another pandemic or cyberattack, they would be met with criticism that they were not meeting their fiduciary responsibility. Potential exposure to climate risk is bigger and more systemic. Our research from the past two years found that the syndicated lending of 28 of the largest US banks is exposed to physical risk. This exposure could cost more than $250bn annually, approaching 10% of these banks’ loan portfolios. At the same time, more than half of bank lending is exposed to transition-related climate risk.
During the past year, record-setting floods, fires and storms caused $145bn in damages in the US. We’ve seen early progress from financial regulators acknowledging the systemic financial risks of climate change, in particular the Federal Reserve’s move to identify climate as a near-term ‘financial stability risk’, and the Office of the Comptroller of the Currency’s proposed principles for climate-related financial risk management. However, the stark reality is that, despite all we know about climate risk and its impacts, there is simply not enough being done by regulators and financial institutions to address it.
There are four important questions that central bank officials must ask themselves. First, has the central bank publicly recognised the systemic nature of the climate crisis and its impact on financial market stability? This recognition should take the form of a statement from an agency chair or an agency-issued report to underscore the risks posed to financial markets.
Second, is the central bank taking steps to integrate climate change into prudential supervision of the financial institutions in its jurisdiction? Bank regulators have explicit responsibilities to supervise the risks that financial institutions take on. Consistent with this authority, financial regulators should integrate climate change into their prudential supervision of banks, insurance companies and other regulated financial institutions.
We admire the leadership of several central bankers who have already taken steps and urged others to assess the climate risk to financial markets, requiring scenario analyses by the banks and other financial institutions they supervise. We believe they should also outline plans for conducting scenario analysis and climate stress tests on these institutions to measure the impact of climate-related shocks and consider enhancing capital and liquidity requirements to integrate climate risk.
Third, what is the central bank’s perspective on climate disclosure? The first step in managing a problem is measuring it. We believe that financial regulators should include climate disclosure requirements for companies in their annual financial filings. Clear, consistent and comparable reporting is required to ensure that financial markets can price and act on the physical and transitional risks and opportunities from climate change.
Finally, is the central bank’s staff versed in climate risk management? Climate change is altering the landscape of financial regulation and bank examiners should be trained on the related physical and transition risks. It is important that central bank staff throughout each agency are trained on these risks. This is one of the most straightforward ways to guarantee the safety and soundness of our financial systems.
It is also crucial to build capacity for smart decision-making on climate change by coordinating action by financial regulators at the global, national and local levels.
Each central bank has a critical role to play in ensuring the resilience of national economies, as well as the global economy, which has already been weakened by the pandemic and is now threatened by future climate shocks. The safety and soundness of financial institutions, and our planet, requires immediate action by regulators worldwide.
Steven Rothstein is Managing Director of the Ceres Accelerator for Sustainable Capital Markets at Ceres. For more information, go to ceres.org/accelerator.