It takes two to Tango –Central Banks and commercial banks, partners in Climate change management

There were two primary principles that I touched in my previous blog Climate change Management- whose job is it anyway.  The first is, boundary definitions with clear responsibility/ accountability for the major stake holders and the second, need for smooth collaboration between them.

Central banks and commercial banks are the critical stake holders of banking industry. They need to “work together” to make a success of the climate change project. Even though each have their specific areas of influence and responsibility, policies, approach, direction, and actual actions by one intrinsically impact the other. The following flow gives a bird’s eye view of the symbiotic relationship between the two.

Climate change is a source of financial risk and can cause different types of risks. The two primary ones are Physical and Transitional risks. These affect economy and thereby financial systems, in multiple ways**and hence are of great concern to both.

1. Business disruption, asset destruction (damage to property, infrastructure, land, produce), migration, lower value of “stranded assets,” increase in energy prices with dislocations.
2. These result in lower property and asset value, lower household wealth, lower corporate profits and more litigation, lower growth, and lower productivity, among others.
3. This affects financial system through market losses (lowering prices of equities, bonds etc.), credit losses (actual defaults, deferred payments), operational losses including liability risks.
4. The impact indicated at 3 above will have negative effect on economy, leading back to item 1, thus forming a vicious cycle

**Adapted from IMF’s Finance & Development, December 2019, Vol 56.

As pointed out by Frank Elderson, Vice chair of the Supervisory Board of ECB, “Whatever combination of physical and transition risks materialize, the macroeconomic consequences and the financial risks resulting from the climate and environmental crisis will be profound.” The regulators are rightly concerned about inflation, prices, employment, productivity, stability of the financial system as well as the safety and soundness of the banking industry. Banks too, are working on the best ways to support their customers with their transition journeys, while having to manage the potential negative financial impact of the combination of physical and transitional risks on their books that could threaten their sustainability and growth.

The big question is, how to draw the boundary of individual responsibility and accountability while collaborating to meet a common goal. There is a quote I came across, in a couple of news items, that shows a potential path of rational delineation “That is not our job. We do not tell banks which sectors to lend to. We ask them to risk manage and we make sure they have good processes in place…” Lael Brainard, Member Federal Reserve Board. This is an important stance from a boundary management perspective. There are three important themes here.

• First, regulatory supervision will not include directives to banks on which sectors not to do business with. Banks are or are supposed to be, mature partners in climate management journey. It is an expectation that they will ensure responsible approach to business so as to be in sync with the environment they operate in. This stand not only empowers banks but also makes them responsible as well as accountable for their actions and commitments.
• Second, banks will be asked to risk manage – Managing the potential negative financial impact of climate change risk on their books rightfully belongs in the realm of banks. Banks are tasked to establish appropriate risk constructs and ensure their efficient and effective enforcement. This is in the interest of banks themselves!!
• Third, through supervision, regulators will make sure that they have good processes in place – This is where the supervisory oversight comes in.

The challenge, arguably, is from banks who could, either in the interest of their revenue or to help their customers. try and operate below the radar. Supervisors have tools, instruments, policies, and procedures to rein in the errant banks that do not fall in line. Effective use of Pillar 2 (Supervisory review) and Pillar 3 (Market Disclosures) will be strong deterrents. The added advantage climate change management efforts has, is the presence of strong credible global organizations that are crafting well thought out disclosure requirements. Examples are TCFD (Task Force on Climate-related Financial Disclosures) framework for disclosures by banks and its counterpart NGFS (Network for Greening Financial System) “Guide on climate-related disclosures for central banks.” The transparency and detail expected from these disclosures, the close scrutiny of active civic bodies, investors/ shareholders coupled with strong social medium, will make it difficult for errant banks to err either above or below radar!!

In my next blog, will look at some interesting vocabulary in the “Green” climate change management space as relevant to banks.

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