4 reasons why banks and insurers can’t withstand the climate crisis without extra loss-absorption capacity

The colossal financial risks arising from the climate crisis are not business as usual. Yet, systemic banks and insurers lobby intensely against a logical increase of their loss-absorption buffers.  However, their counter-proposal – to stick to “soft regulatory measures” – won’t  protect European taxpayers.

Financial supervisors are increasingly concerned about the links between climate change and financial stability. They are right – If no action is taken now, the economy and the financial system are inevitably heading into a climate-induced financial crisis.

Finance Watch 4 reasons why banks and insurers can’t withstand the climate crisis without extra loss-absorption capacity

In the scenario of an orderly transition to a carbon-neutral economy, many of the assets associated with the fossil fuel industry will need to be abandoned before the end of their economic life[1] (stranded), at huge cost for the financial institutions which provide financing and invest into fossil fuel companies.

And in the business as usual scenario of unabated climate change, the impacts of a 4°C average temperature increase would wipe out tens of trillions of dollars from our economy, to which banks and insurers are intricately exposed via ever more frequent and extreme climate events. Thus, continued financing of the fossil fuel industry will inevitably result in massive losses for the giants of finance, which have the potential to trigger a financial and economic crisis.

Yet, banks and insurers – the institutions that are of major systemic relevance for the financial system and economy overall – massively underestimate these risks, as recently confirmed by the ECB’s thematic review of banks’ climate and environmental risk management frameworks. Investment in and financing of the fossil fuel industry is still treated as any other type of corporate financing from the risk perspective which means that banks’ and insurers’ capital buffers will prove largely insufficient to cover the losses looming on the horizon.

Finance Watch 4 reasons why banks and insurers can’t withstand the climate crisis without extra loss-absorption capacity

This situation is profitable for big finance and for the fossil fuel industry. Artificially low capital buffers imply higher leverage which increases the return on capital and benefits of financial institutions, but it also artificially lowers the financing cost for fossil fuel projects. For the citizens as taxpayers, this situation is extremely dangerous as it shifts the cost of a possible future financial crisis triggered by climate change onto their shoulders – in the form of taxpayer bailouts and other forms of help, which the governments will deploy to save financial institutions.

But if financial institutions underestimate climate risk, it is for very structural reasons and this won’t change in the foreseeable future – unless credible regulatory measures are put in place. Despite the financial lobby’s rhetoric in policy making circles, we see four reasons why the upcoming batch of “soft” regulatory measures in the banking and insurance prudential rules – disclosures, climate stress tests, consideration of climate-related risks in strategies and risk management etc. – will not protect them from climate-related risk at the scale required.

All market participants will soon be forced to apply new European sustainability disclosure rules – a crucial first step towards transparency. Once there is sufficient reliable and comparable data on these risks, one could hope markets will fully price them in and financial institutions will incorporate them into their risk management.

However, the story is more complex. The specific features of climate-related risks which makes them impossible to predict and model also prevents them from being fully and accurately reflected in market prices. The most extreme climate-related events – defined as “green swans” – will inevitably lead to major disruptions to our planet and economy; yet, the timing of their arrival and their scale are impossible to predict. The time horizon of climate-related event materialisation is therefore to a large extent unpredictable and can be also significantly longer than the horizon of the current business forecasting, planning and risk management. This adds up to scientific evidence suggesting that even in the sectors where physical climate risks have been studied, equity prices still do not adjust to[2] fully incorporate risk.

Another overemphasised avenue partisans of “soft” measures keep pushing  to avoid capital increases, is the argument that the internal risk management approaches of financial institutions  are allegedly best suited to understand and measure climate-related financial risks (the pillar 2 of the prudential framework).

As these approaches are eventually reviewed by the supervisors, the ECB´s 2022 thematic review has confirmed that banks’ risk management frameworks are not yet up to the expectations.

A lot of work is yet to be done before banks can accurately identify and measure climate risk in an effective, comparable and credible way. Not only do the specific features of climate risk (as was mentioned above) prevent the effective translation of climate-related events into financial impacts on institutions’ portfolios[3], there are still major challenges in terms of data gaps, methodologies and metrics.

We cannot expect internal assessment approaches of even one individual financial institution to be able to overcome these challenges meaningfully in any foreseeable future. Even the insurers, who by the nature of their business have a vast experience in climate event modelling, face major difficulties when dealing with uncertainty inherent to climate-related risks, as uncertainty cannot be modelled.

With this much uncertainty, financial actors will always be tempted to individually downplay the risk, which leads to the systemic risk building up in the financial system (this is another “moral hazard” that all climate finance observers should keep in mind). This risk can eventually materialise for taxpayers in the form of bailouts for failing financing institutions – albeit with a time delay. This important aspect has been emphasised by the experts of the Intergovernmental Panel on Climate Change in its Sixths Assessment Report[4].

Supervisors put a lot of value on the so-called “climate stress tests” as a tool to identify and manage climate risk. They hope that the simulations of different possible climate scenarios will allow financial supervisors to engage bilaterally with institutions and address climate risk vulnerabilities on a case by case basis. The necessary measures to address vulnerabilities and risks could then be targeted to each institution, even possibly to include capital add-ons should a supervisor determine that an institution’s capital would not be sufficient to cover losses in a stress scenario.

While the results of climate “stress tests” offer valuable insights which help illuminate  climate vulnerabilities and shape supervisors’ actions, these “stress tests” have significant structural limitations. For one, they mostly focus on the “transition risks” and are able to factor in physical risk to a very limited extent only. Importantly, they ignore the disruption risk dimension  (i.e. are not capable of modelling major extreme climate-related events which represent the biggest risk to the economy and the financial system).

Further, the “stress tests” suffer from many methodological limitations such as uncertainties about the transmission channels between climate events and financial balance sheets. All of this may explain why unlike traditional financial stress tests, the so-called “climate stress tests” are not even intended to lead to conclusions about the capital adequacy of tested financial institutions. Effectively, these are only exploratory scenario analyses rather than “stress tests” in the established definition[5].

On the one hand, banks and insurers are already supposed to integrate climate and environmental risk considerations into their governance and business strategies.

European supervisors (e.g. ECB and EIOPA) have appropriate guidance in place and the Basel Committee has also come up with respective Principles. These supervisory principles are supposed to help overcome short-termism in the management of risks and align long-term commercial goals with the EU climate objectives.

Yet, the largely high-level principle-based provisions are unlikely to change behaviours at scale. Sustainability dimension of corporate governance needs to be significantly strengthened to account for the public good nature of our environment and align financial institutions’ strategies with the objectives of environment preservation.

Without legal obligations related to managing bodies, internal controls and remuneration systems to support the objectives, there can be no salubrious “level playing field” among market participants.

In the short-term, the most ambitious long-term oriented financial institutions could find themselves at a competitive disadvantage compared to those extracting profits from continued financing of the fossil fuel industry while contributing to the ever growing systemic risk.

Many more arguments could be brought in about “soft” prudential measures and to counter the “myths” spread by the financial lobby to avoid stronger regulation on capital requirements.

Overall, the new context of climate-related radical uncertainty changes the condition of operation of financial supervisors and requires new precautionary prudential regulatory measures. The magnitude of the climate crisis compels our big financial institutions to build-up loss-absorption capacity – capital buffers –  to protect society from a climate related financial crisis. Raising the risk weights for exposures to fossil fuel assets is the logical place to start with, as these exposures are so obviously, so undoubtedly feeding micro and macro prudential risk. This approach fits into the existing provisions of the prudential frameworks, where assets associated with risks deemed higher can be subjected to higher capital requirements.

The Basel Committee has already recommended precautionary conservative capital treatment of crypto-asset exposures. It is urgent that the mounting risks of stranded assets and climate-related collapse are also recognised in the regulation, as these represent a much bigger ticking bomb. The necessary amendments have been proposed by the Members of the European Parliament in the ongoing review of the Capital Requirements Directive, Capital Requirements Regulation and the Solvency II Directive. Support from the co-legislators is now required throughout the negotiation process to make sure these amendments are reflected in the legislative texts to be finalised later in 2023.

Pablo Grandjean and Julia Symon

[1] Read, for example, this cover of the comprehensive 2021 International Energy Agency report on Net Zero: https://www.theguardian.com/environment/2021/may/18/no-new-investment-in-fossil-fuels-demands-top-energy-economist

[2]ECB “Climate-related risk and financial stability – Financial markets and climate risks”, July 2021, p. 36-37. https://www.ecb.europa.eu/pub/pdf/other/ecb.climateriskfinancialstability202107~87822fae81.en.pdf

[3] “BIS, Climate-related financial risks – measurement methodologies; Climate-related risk drivers and their transmission

channels, April 2021.  https://www.bis.org/bcbs/publ/d518.pdf

[4] Chapter 15, page 15-60

[5] Read footnotes 7 and 10 of the BIS Principles https://www.bis.org/bcbs/publ/d532.pdf