Banking supervisors are increasingly concerned about the links between climate change and financial stability. At the heart of the issue is banks’ financing of fossil fuels, which are the main contributors in accelerating climate change.
Because of this, many of the assets associated with the fossil fuel industry will need to be abandoned before the end of their economic life (stranded), to achieve the transition to a carbon-neutral economy, at huge cost for financial institutions. Estimating and managing these new financial risks is now a key focus for prudential authorities around the world.
In our study, Finance Watch estimates that the 60 largest global banks have around $1.35 trillion of credit exposures to fossil fuel assets on their balance sheets. However, the higher risks related to these assets are not reflected in bank capital rules.
The most effective way to do this would be through a Pillar 1 measure now being explored by legislators in the EU and Canada:
Apply a 150% sectoral capital risk weight to banks’ exposures to existing fossil fuel assets.
This new study aims to help legislators assess this proposal by quantifying the capital impact on banks and looking at the implications for lending and supervision. We conclude that the measure would be feasible to implement without reducing lending capacity, making it a very achievable solution to protect taxpayers from the build-up of systemic risk.
Measuring the solution – Quantifying the additional capital
Our study looks at the 60 largest global banks, including the 28 banks considered to be systemically important at a global level and the 22 largest EU banks by assets. It finds that applying a 150% risk weight – which is the risk weight applicable for higher risk assets under the Basel framework – to banks’ exposures to existing fossil fuel assets would require total additional capital equivalent to around 3-5 months of those banks’ profits.
The average additional capital per bank would be $3.05 billion and for half the banks in our sample it would be $1.81 billion or less. This is equivalent to 2.85% of the banks’ current equity or 3.42 months of their 2021 aggregate net income. Half of the banks could cover this from profits in 2.71 months or less – if they started today, they would be finished by Valentine’s Day! However, some outlier banks would need longer because of their high exposures to fossil fuels or low profitability in 2021.
In practice, banks would have longer to respond because such capital measures are normally phased in over longer periods.
Small change, not a radical one – Implications for lending
We believe the capital gap can be feasibly bridged by retaining profits over reasonably short periods of time without a reduction in overall lending capacity, which is important for supporting a sustainable transition.
A much larger capital increase was implemented following the global financial crisis, when banks achieved their targets over 18-24 months without any reduction in lending or total assets, by using a combination of retained profits and higher lending spreads.
Once lawmakers apply a sectoral risk weight for fossil fuel exposures, supervisors should work with banks to achieve the needed capital increase over a suitable time frame. This would ensure that an identifiable category of risk is addressed in a timely way and is well managed from a systemic perspective. This would also prevent cliff effects of abrupt risk materialisation and fire sale dynamics related to a possible disorderly transition.
Officers out on patrol – Implications for supervision
Several aspects could be relevant for supervisors when implementing the measure:
- If supervisors introduce the higher risk weight over a time period that accounts for the scale and maturities of banks’ existing fossil fuel exposures, they could avoid disruptive effects on current lending, for example through the impacts on loan pricing and covenants.
- The time period should also be long enough to reflect banks’ ability to generate capital organically through their profitability, which is currently on an upward trend as interest rates rise. Having a suitable implementation period would ensure that the measures do not reduce banks’ lending capacity. However, banks with low profitability or high fossil fuel exposures may need more time to implement the measure.
- In the EU, new rules on banks’ ESG disclosures will apply from December 2022, which means supervisors will be readily able to identify assets where the 150% risk weight applies without deploying additional supervisory resources, making this an easier (and more effective) way to address the prudential gap than some other approaches.
- Some of the additional capital estimated in this study will overlap with new capital that banks need to raise anyway for the final implementation of Basel 3, including the output floor. We estimate the overlap could reduce the additional capital by around 10%.
- Supervisors could fine-tune capital treatment at individual banks through discretionary Pillar 2 measures, for example to reflect climate-related concentration risks or the quality of bank clients’ transition plans.
The benefits of this approach include:
- Banks would remain free to lend to fossil fuel companies at risk-adjusted market prices. As this is a purely prudential measure against banking losses, supervisors will not be accused of playing politics.
- The ‘higher risk’ treatment would provide a cushion for banks against the risk of cascading losses from depreciating assets and fire sale dynamics. Having more loss absorbing capacity is the only effective way to increase banks’ resilience against the unpredictable and disruptive effects of climate change.
- The transition to higher risk treatment could begin now, without having to wait years for advances in climate risk modelling on which to base individual banks’ risk management (well-knowing that the existing models are not able to capture the radically uncertain and forward-looking nature of climate-related risks in any case). This would avoid the effects of modelling errors and would shorten the time in which climate-related financial risks can accumulate, in turn reducing the chances and impact of a disorderly adjustment in future.
Ending the Subsidy for fossil fuels
The current practice of not treating banks’ fossil fuel exposures as ‘higher risk’ enables banks to provide financing at artificially lower rates to fossil fuel companies. As the credit risk remains with the bank, this is effectively a subsidy from banks to the fossil fuel industry which reduces the efficiency of banks’ credit allocation.
Using McKinsey’s forecast for banks’ expected return on equity in the next few years (7% to 12%), we estimate that this transfer of value is worth around $18 billion a year. This is the equivalent of banks under-pricing their $1.3 trillion portfolio of exposures to fossil fuel assets by 1.3% a year.
This ‘subsidy’ puts the financing of sustainable and transition projects at a clear disadvantage.
The prudential reform outlined above can help address this problem, while also providing a much needed safety net for economies and wider society.
In Europe, the ongoing legislative review of bank prudential rules – Capital Requirements Regulation and Directive – is a unique opportunity to introduce a sectoral risk weight for fossil fuel exposures. Supervisors should then work with banks to phase in the changes over a suitable timeframe that protects banks and their clients from adverse consequences while the prudential gap is plugged. This is key to protect European banks from climate-related risks associated with financing the fossil fuel industry and disruptions due to accelerating climate change, without reducing their capacity to lend. In the US, Canada or UK, the equivalent reform should be considered by relevant supervisors, for regional banks.
- If you can help Finance Watch with the ongoing review of CRR/CRD (ECON Committee of the European Parliament, vote in December), please contact Paul Fox.
- Please consider also retweeting our open letter calling on the G20 for a #safetransition (also on Linkedin)
- To dive deeper in the topic, read Finance Watch’s landmark report “Breaking the climate-finance doom loop – How banking prudential regulation can tackle the link between climate change and financial instability“