8 lobby myths about higher capital requirements for fossil banking

The bank lobby usually argues that higher capital requirements for fossil fuel financing wouldn’t be “risk-based” but such a measure would boil down to misusing the prudential rules as an economic policy tool in order to establish the “brown penalising factor” targeted at polluting sectors – for example, environmental and therefore non-prudential reasons.

Finance Watch response: 

Higher capital requirements for fossil fuel financing would reflect the risk stemming from the fact that assets related to fossil fuel exploration and production will be largely abandoned, (i.e. become stranded), and therefore lose a significant part of their value, in the course of transition to a low-carbon economy. The measure is purely risk-based and is not meant to incentivise or disincentivise behaviours as such. Stranding and value loss will happen as governments deliver on their climate neutrality objectives in line with the commitments to achieve net zero emissions by 2050 as per the Paris Agreement. (The International Energy Agency (IEA) concluded that there is no room for new fossil fuel exploration after 2021, as the demand for fossil fuels will drop sharply in the case of an alignment with the Paris objectives: by 90%, 75% and 55% for coal, oil and gas respectively. This paints a clear picture of value loss for the fossil fuel industry.). On the other hand, in case the transition does not  happen and net zero objectives are not achieved, the economy  will be disrupted by major climate-related disasters (referred to as  “green swans” – a term introduced by a book by the Bank for International Settlements (BIS) – the “Bank of Central Banks”, in charge of financial stability) and  financial institutions, in turn,  will be destabilised to a much bigger extend. The CEO of one of the world’s biggest insurers even said that the world at +4°C temperature rise would be “uninsurable“. This speaks about the extent of the financial risk of unabated climate change. In both cases, by continuing to finance fossil fuel assets, financial institutions expose themselves to material and significant financial risks, putting fossil finance squarely into the prudential mandate of financial regulators and supervisors.

As long as no resolute prudential action is undertaken, these climate risks will keep piling up in the financial system, increasing the probability that climate change triggers the next financial crisis. Finance Watch’s proposal is to reflect this risk in financial institutions’ capital requirements without further delays (implementation of legislative changes will anyways take years), to stop the build up of climate-related financial risks by gradually pricing them in. The current lack of integration of these risks maintains fossil fuel financing artificially cheap, as its cost does not include a price for climate-related risk, amounting to a hidden subsidy to the fossil industry and effectively incentivising more risky investments.

We are not trying to “politicise” the prudential framework, but proposing to apply it in a more consistent, risk-based manner where capital requirements are calibrated to reflect basic risk management principles and ensure the internal coherence of prudential regulation, i.e. treat comparable risks in a comparable manner, which is not the case today for fossil fuel exposures. For more on this, read our landmark report “Breaking the climate-finance doom loop”.

A recurring argument from the financial lobby is that there is not enough data to take action on capital requirements, as the risks are not yet well quantified. According to the European Banking Federation, we should  wait until the obligations on non-financial reporting kick-in, and until supervisors agree on standardised methodologies to quantify climate risk. Only then can they decide on appropriate prudential measures.

Finance Watch response: 

Whilst quantifying and measuring are “usual” ways to understand and manage financial risks, this will not work with climate-related financial risks. This is due to the fact that climate change is characterised by irreversible and non-linear developments, and climate-related financial risks have specific features, which pose significant challenges when it comes to deploying traditional approaches to tackle them. For such types of unquantifiable yet “higher risks” assets, supervisors usually endorse the qualitative approach. It has been recently done  for bank exposures to cryptoassets.

The reason why the strictly quantitative approach doesn’t work with climate risk is that, in the case of climate change, we are not dealing with risk, but with uncertainty which is impossible to quantify based on historical data. Climate-related events are defined as “green swans” and are characterised by: i) certainty of their occurrence but highly uncertain impacts and the impossibility to determine the exact timing of their materialisation; ii) wide-ranging and existential impacts on the economy and the financial system; iii) a high degree of complexity, including cascade effects and chain reactions in the environment, economy and society.

The situation is therefore an unusual combination of an absolute certainty on the direction of travel and its dire consequences, and of an absolute uncertainty on the quantification of what will happen beyond the tipping point. Policy-makers, regulators and academics alike are not equipped to deal with such an unusual situation. Their usual way of approaching the world is to analyse a prevailing situation, using historical  data, and to extrapolate it into the future to get a sense of what will happen, before undertaking any measures. Unfortunately, this also remains their approach to climate risk, which ignores  the specific nature of climate risk. This approach will not work –  history and data cannot tell us anything about the state of the world ‘beyond the global warming tipping point’ for the simple reason that we have never been there. Policy-makers and regulators have to realise that when it comes to climate change, deciding to wait for the right measurement before acting is equivalent to deciding to do nothing and waiting idly for the disaster to strike. Good intentions will not be sufficient.

Second, the magnitude and probability of future disruptions is growing with prolonged inaction. The climate impacts are increasing as long as no tangible actions are taken to reduce greenhouse gas emissions. Once global temperatures have exceeded their pre-industrial level by 2°C, the consequences on human society and the global economy will be irreversible and largely unpredictable. Absence of timely both prudential and environmental resolute actions is a guaranteed path to disorderly transition and the materialisation of systemic risk.

The banking lobby often says any higher capital requirements on fossil fuel investments would reduce the ability of banks to finance the transition towards a low-carbon economy, as capital will be held unproductively and banks cannot allocate it to new loans for the real economy.  

Finance Watch’s response:

This argument is flawed, as it overlooks the fact that capital forms the core tool to ensure the resilience of financial institutions in case of a crisis and, thereby, their continuous ability to service the real economy. Safer (i.e. better capitalised) banks cannot hurt the economy, the analysis shows.

If climate-related financial risks remain unreflected in the capital rules and, thus uncovered, the looming climate crisis will trigger a financial crisis and disrupt the supply of credit. As a consequence, taxpayers’ money will have to be used to bail out failing banks, as was the case in the financial crisis of 2008.

The current lack of consideration of climate risk in prudential rules, leads to a situation where fossil fuel financing is effectively subsidised, which puts sustainable activities or activities transitioning towards sustainability at a disadvantage in terms of attracting finance.  Moreover, banks are not the only actors in financing transition. There is a big role for the government to play as many green investments are not bankable (i.e. do not have stand-alone investment cases for potential investors and lenders).

Importantly, banks are free to decide how to meet their capital targets – by cutting lending or raising capital by issuing equity or retaining earnings. There is an existing precedent for the implementation of capital measures – the capital increases required to implement Basel reforms after the financial crisis were achieved by retaining profits, without a reduction in bank lending or asset volume. Also, any capital measures would be implemented over a sufficient period of time, which gives banks time to adapt gradually.

Ultimately, banks’ share of green financing remains extremely low compared to fossil related one. This reveals the hypocrisy at the heart of this argument.

One of the EBF’s arguments is that in the last 12 years, banks have accumulated sufficient capital. They would even maintain a 5% voluntary buffer on top of regulatory minimum capital requirement. EBF members actually seek to reach an optimal level of capital, which is around where banks are now, any new capital increase would threaten this careful balance.

Finance Watch’s response:

Whether the current level of bank capital is overall  ‘optimal’ or even sufficient deserves a separate discussion (Spoiler alert: Finance Watch doesn’t think so). Still, the EBF argument ultimately ignores the question if banks account for climate-related risks when determining their level of capital. The answer is straightforward – supervisors and experts recognise climate risks are not yet reflected in the market prices (Read our analysis of the IPCC Sixth Assessment Report and the latest ECB thematic review) and in prudential capital requirements (See the ECB macroprudential bulletin here).

If banks already maintain a voluntary 5 per cent over minimum capital requirements, they would not even need to raise capital in case requirements for fossil fuels-related financing are increased, and it would therefore not make sense to fight against the measure on the grounds that higher capital is detrimental to lending capacity.

Indeed, in our recent study, we demonstrated that introducing higher capital requirements for fossil fuel financing would increase the minimum required capital to financial institutions of less than 3% of the current capital stock (globally and in the EU). This would only cost the banks in the EU on average up to 5 months of retained earnings and would not jeopardise their ability to provide credit.

Finally, the post-2008 crisis package of measures has not even been fully implemented and yet it is already at high risk of significant capital concessions being given to the EU banks at the cost of financial stability, as the EU Commission’s package is currently under review and  being watered -down due to  pressure from the bank lobby (Read this recent warning by top EU supervisors).

According to the European Banking Federation, EU banks are already reducing their financing provided to the fossil fuel industry and what’s more, they are probably doing it too fast given the current energy crisis.

(Screenshot from the EBF’s slides)

Finance Watch’s response:

The graph above presented by the EBF to support their claim, captures the flow (as opposed to stock) of fossil financing, which includes underwriting & lending flows over a period of time, whereby not all of these exposures remain on the balance sheet (i.e. may mature or be sold on the capital markets). This is not the type of data used to determine capital requirements (which is stock of exposures as of date). The decreased volumes of fossil fuel financing, as shown on the graph, might be related to the decreased capital market activity in the EU (for example, when Exxon issued less debt obligations, whilst banks might have maintained the same volume of lending to Exxon’s fossil fuel exploration and extraction activities), but do not provide a picture of the actual stock of fossil fuel exposures as of a reporting date.

In any case, given the opacity of banks on their climate risk exposures and until the EU reporting standards come into force (the ECB says banks must get better at disclosing their climate risks), it will remain impossible to verify the EBF’s claim.

And if banks were actually reducing financing of fossil fuel-related activities themselves, it would mean that they already recognise the high risks associated with such financing (in the ECB thematic review 2022, 80% of banks said they view climate risks as material). Then, why resist it being reflected in the capital rules, which is the purpose and mandate of prudential regulation?

The bank lobby usually says that  additional capital requirements for fossil exposures would hurt the availability of financing for fossil fuel companies, which would in turn reduce energy production and increase fuel prices for the end consumer. This could put the access to energy of EU citizens at risk, pushing them into energy poverty.

Finance Watch’s response:

As discussed earlier, banks are free to decide how to meet their capital targets – by cutting lending or raising capital by issuing equity or retaining earnings. There is an existing precedent for the implementation of capital measures – the capital increases required to implement Basel reforms after the financial crisis were achieved by retaining profits, without a reduction in bank lending or asset volume. Furthermore, any such capital measures would be implemented over a sufficient period of time, which gives banks time to adapt gradually. (Editors’ note: see myth #3 on past precedent of capital increases). Importantly, banks’ ability to accumulate capital by retaining earnings is very much on an upward trend as interest rates are anticipated to rise for the foreseeable future.

The EBF is right to say that additional capital needs to be remunerated, (i.e. banks need to earn return on such capital). This would indeed imply an increase in the price of financing for fossil fuel borrowers. But in the current circumstances of high energy prices and windfall profits for fossil fuel companies, an increase in the cost of financing would be very manageable. 

What is important to note is the proposed capital measures would not apply to sustainable projects set up to support the transition efforts.

On the other hand, delaying action – both on financial regulation, as well as other actions to reduce economies´ dependency on fossil fuels – is exactly what will result in increasing energy prices as transition becomes disorderly. This will become more evident and extreme if the capacity of renewable energy sources has not grown in due time and financing continues to flow into fossil fuels.

An example of what this disruption will look like as fossil fuels are phased out in a disorderly manner, is the energy crisis related to the war in Ukraine, where the entire energy market has been severely upended by sanctions and counter-sanctions due to the European reliance on Russian gas.

The European Banking Federation  claims that the ”accounting framework” is suited to deal with stranded assets (i.e. that climate factors are already partially reflected in the values of the financial assets, as reported in companies’ financial reporting statements.)

Finance Watch’s response:

This is incorrect. As per the IPPC’s Sixth Assessment Report in Chapter 15 (read our blog on this), research has concluded that prices of assets as reflected in the accounting frameworks do not yet reflect climate risk in any way, shape or form.

Among structural reasons for this, the IFRS’s current reporting framework focuses on “fair value” and implies high  discount rates which prevent accounting from adequately reflecting the future value of the assets today.

Current efforts to enhance disclosures such as the work of the International Sustainability Standards Board (ISSB) and the European Financial Reporting Advisory Group (EFRAG) are dedicated to increasing transparency so that the risks may be better priced in the future. However, the ambition of these efforts is already being watered-down. And even with the best of disclosures, transparency is only a prerequisite – not sufficient by itself, to correct market inefficiencies and ensure prices fully reflect climate-related risks (read part III of our report “A Silver Bullet against Green Swans” ).

The banking lobby also argues that increased capital requirements would trigger massive and sudden sell off of fossil assets, thus “self-fulfilling” the risk of stranding these assets. 

Finance Watch’s response:

The risk of asset stranding is already very real due to the concrete targets to reduce fossil fuel consumption. The International Energy Agency (IEA) concluded that there is no room for new fossil fuel exploration if emissions are to reach net zero by 2050, as the demand for fossil fuels will drop sharply –  by 90%, 75% and 55% for coal, oil and gas respectively. There is a significant body of research on stranded assets (i.e. Finance Watch’s report and other relevant literature) which suggests significant economic disruption from the transition is extremely likely.

Increasing capital requirements is a way to ensure that the markets price in the  risk of stranding progressively (it would take several years from the regulation change to fully phased-in increased capital levels) so that the transition can happen in an orderly rather than disorderly manner, the latter becoming more likely the longer we delay taking action. In case we do not start the transition in a timely way (now), a disorderly transition scenario is unavoidable. We are likely to see abrupt market swings and sudden huge sell off of fossil assets at a later stage, which coupled with an aggravated climate crisis and undercapitalised banks, provides the perfect conditions for a next financial crisis.