International Banking Regulation and Climate Change

International organizations, national governments, and the private sector have adopted ambitious policies to address climate change and other environmental challenges. The 2015 Paris Climate Change Treaty and the United Nations Sustainable Development Goals (SDGs) are part of many international initiatives to address the economic and social risks arising from unsustainable economic activity. The Intergovernmental Panel on Climate Change (IPCC) reports that human activity is unequivocally causing our climate to change, and this is already affecting every region of the World. The G20 and the Financial Stability Board have both pointed out the inconvenient truth that climate change is a systemic threat to financial stability. 

As economies adapt to climate financial risks, asset price volatility, restricted credit, and increased borrower defaults will rise in economic sectors that the market has determined to be environmentally unsustainable. Evidence suggests that market discipline, on its own, cannot adequately control the externalities in financial markets associated with climate change risks. Mark Carney, former Governor of the Bank of England, called this ‘the tragedy of the horizon’ because the costs of taking action are borne in the short run but the benefits accrue to future generations. Combine this short-termism with the relentless political cycle in most countries, and the likelihood of delay in taking appropriate actions for achieving long-term sustainability increases dramatically. Delayed actions to avoid a financial and environmental crisis—or to deal with it once it happens—also become more costly.

Banks are taking small steps

Banks play an important role in supporting the broader economy’s adaptation to a more sustainable society and in building resilience to the financial risks associated with environmental change. By reallocating credit to more sustainable sectors of the economy and managing the related credit, liquidity and market risks, banks contribute to adapting to the consequences of environmental change over time, reducing the likelihood of environmental sustainability risks, mitigating the impact of these risks when they materialize and supporting recovery from any given impact. 

Climate change poses material financial risks for the banking sector, which are not factored into the business decisions of individual banks. It’s up to regulatory authorities and banking institutions to better manage these environmental systemic risks—and at the same time redirect capital toward sectors that are contributing to a more sustainable future. 

Regulation to the rescue

A growing number of countries have taken steps to incorporate environmental sustainability risks into financial regulation. The European Commission adopted the Action Plan on Sustainable Finance and created the Technical Expert Group on Sustainable Finance (2018) to oversee the implementation of legislation requiring EU regulators to adopt a prudential approach to climate and environmental risk management for banks. The European Banking Authority and the European Central Bank are at the forefront of initiatives to incorporate climate-related risks into risk management and supervision and stress testing.

The range of instruments available to the authorities should consider the various stages of the supervisory process, from licensing to sanctioning and crisis management, with emphasis on a holistic approach to balance sheet regulation, looking at the various elements that make up ‘safety and soundness’. Such elements are summarised in the acronym CAMELS—Capital, Assets, Management, Earnings, Liquidity, and Sensitivity to market risk—used by the US Federal Supervisory Authorities (and similar internal rating systems are used in other jurisdictions) to which we would add another S for Sustainability (CAMELSS).

Since 2010, China has required banks to take account of sustainability risks in their risk management and business model analyses. China also adopted the Green Credit Guidelines in 2012 that encourage banks to enhance their ESG practices. Similarly, the Central Bank of Brazil requires banks to report on environmental risk exposures and to conduct stress tests for environmental phenomena, while Peru requires that banks require commercial borrowers to conduct sustainability due diligence assessments for large lending projects. These policies are largely uncoordinated, however, and experience suggests that international regulation should have a bigger role to play in developing harmonized standards.

Despite national and regional efforts to address the financial stability risks associated with climate change, more harmonised regulation is needed at the international level to control and limit the externalities associated with climate financial risks. 

The Basel Committee on Banking Supervision, the global standard‑setting body charged with international rules and standards covering bank capital, liquidity, corporate governance and risk management, administers the Basel Capital Accord, consisting of three pillars: (1) Minimum Capital Requirements, (2) Supervisory Review (bank governance) and (3) Market Discipline (disclosure to the market). The Basel Committee in June 2022 issued regulatory and supervisory principles for national authorities to apply to banks that would incorporate climate financial risks into their risk management practices and business models. 

Although the Basel Committee’s principles are an important first step, the Committee should develop a more harmonised international approach for the collection and analysis of credit, market and liquidity risk data and to refine the banking sectors’ understanding of what sustainable economic activity is and of how much capital and liquidity banks should hold against climate finance risks. For example, the European Commission ‘Taxonomy’—a classification system for sustainable economic activities provides banks and investment firms with more clarity about whether their lending and investment strategies are oriented toward sustainable development objectives.

Regulators can also play an important role under pillar 2 of Basel III by requiring banks to conduct stress tests involving scenario analysis that incorporate forward-looking scenarios that estimate the potential financial stability impact of supplying credit to environmentally sustainable or unsustainable activities over time.

And, under pillar 3, regulators can require banks to disclose information about how they are managing the environmental systemic risks they face. Shareholders have used this approach in the US by proposing resolutions that would require a bank’s board to disclose the institution’s exposure to high-carbon activities.

The role of international financial regulation should be to promote more standardization and comparability between institutions and jurisdictions. The Basel Committee and other international standard setters should seek harmonisation in supervisory approaches aiming to have common standards and rules on pillar 1 methodologies for calculating climate related risks, pillar 2 governance standards for integrating sustainability risks into banks’ business models and stress testing, and pillar 3 disclosures consisting of both qualitative disclosures (eg, based on voluntary codes and industry standards) and quantitative disclosures defined by the financial regulators working with the accounting industry. 

Banking executives tend to lobby reflexively against the idea of new regulation, citing their professed market discipline and risk management protocols. But policymakers should remember what former US Federal Reserve Chairman Alan Greenspan told Congress in the wake of the 2008 financial crisis: ‘Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief’.

To be sure, international regulatory intervention, if not calibrated properly, can also produce market distortions that can result in further externalities and misallocations of capital and investment. Thus, a careful combination of market innovation and policy frameworks that suit national circumstances may be needed. As banks are the largest providers of credit for most economies, how they manage these risks is an important policy and regulatory concern. So, too, is the desire to encourage efficient bank lending and investment in productive activities of the economy. It’s increasingly clear that climate change is changing the calculus of what we consider productive. It’s time for banking regulators to respond.

Kern Alexaner is the Chair for Law and Finance at the Faculty of Law at the University of Zurich.

Rosa Lastra is the Sir John Lubbock Chair in Banking Law of the Institute of Banking and Finance Law and the Centre for Commercial Law Studies (CCLS), Queen Mary University of London.