The thing about financial crises is they surprise you. While governments (rightly) fret about interest rate risk hidden in banks’ balance sheets, climate risks continue to build in the shadows. Unless banks reset their financial statements, and regulators their models, for the reality of accelerating climate change, investors and the planet will end up worse off.
The reasons to be worried are twofold. First, climate risks are being ignored in banks’ financial statements, which means they are likely being left out of banks’ capital stewardship. Second, banks’ blind-spot for global warming is allowed to persist by a regulatory regime that also understates the expected consequences of climate change.
A good place to start in scrutinising whether climate risks are properly reflected in banks’ accounts is the assumptions they make on expected credit losses (ECLs)[1]. Not only are ECL assumptions important to banks’ reported financial strength (high ECLs mean lower profits and capital) but they are also subjective. To determine ECLs, banks project future growth and also sector and location-specific factors that could influence default rates.
Climate change will likely impact both. Scientists outline in detail how chronic and acute changes to weather patterns (whether drought, flooding, hurricanes, heat stress or deep freezes to name a few) are expected to harm human wellbeing. Tightening regulation to bring down carbon emissions and accelerating technological innovation are likewise expected to upend carbon-dependent industries. Whether it is mortgage lending in exposed coastal regions, or project finance to the oil and gas sector, risks of defaults will rise without mitigating action[2].
However, when we look at banks’ ECL assumptions there is normally silence on climate risks.
Wells Fargo’s latest financial statements, for example, use three scenarios to underpin ECL assumptions. None considers climate change. They forecast for two years and then assume a return to historical norms. What happens if there is no likelihood of returning to historical norms due to global warming, or the renewables revolution?
The few banks that refer to climate risks in their accounts, tend to conclude that it is not material. HSBC, for instance, states: “Management has considered the impacts of climate-related risks on HSBC’s financial position...[and] do not consider there to be a material impact on our critical judgements and estimates ….”. When precisely will rising risks become material?
To be clear, this is not about banks stopping all financing of activities that carry climate risk. It is, rather, about ensuring these risks are properly costed and reflected in decision-making.
To understand banks’ decision to leave climate change out of their accounts, it is instructive to consider climate stress-testing by prudential regulators.
The Network for Greening the Financial System (NGFS) – the 127 Central Banks leading work on climate – models a cumulative 8% hit to GDP by 2050 under their Current Policies scenario (3°C warming by 2100). This equates to minus 0.3% a year; almost a rounding error to steady state growth. Moreover, the models assume the impacts only really show up after 2030, enabling delayed action[3].
Using NGFS models, the ECB’s 2022 Climate Stress Test found that, under a ‘hot house’ scenario of 3°C warming or greater, banks projected a vanishingly small 0.005% increase in loan losses for the 10 years to 2030, and projected a similar low impact under a scenario of disorderly net zero transition. Losses rise over the years, but never go above 0.195% of performing loans.
How can this be consistent with scientists’ warnings of devastating economic hardship?
According to recent analysis by the Institute and Faculty of Actuaries and the University of Exeter, models such as NGFS are flawed because they assume away the most impactful climate harms[4]. Climatic tipping points that will likely result in self-reinforcing feedback loops, such as the abrupt thawing of the Boreal permafrost, and social responses like mass migration or conflict, are omitted.
On the transition side, too often banks’ models focus on a narrow set of variables – notably a rising carbon tax[5]. Sector-specific transitions are assumed to follow a steady – rather than an accelerating – path. This is an improbably narrow and cautious interpretation of the economic impacts of the clean technology revolution underway. It leaves banks unprepared for the transformation to come.
While the flaws in economic modelling help to explain climate complacency in the banking sector, they do not make it ok. Instead, they should galvanise urgent action.
First, the prudential regulatory regime needs to be made more prudent. Models should be recalibrated to reflect the science and central banks need to demand that more capital is held today against climate-exposed financing. If risks come down, capital may be released. Waiting until risks materialise will result in greater financial instability, not less.
Second, in line with accounting requirements, banks need to take a prudent view of climate risks in their financial statements. Auditors must demonstrate that they have kicked the tyres on the key assumptions. Regulators should sanction banks and auditors that do not. These are also the expectations of a global investor coalition representing $70 trillion coordinated by the IIGCC, which released its vision for a net zero-aligned banking sector in June.
Climate change is not a hypothetical scenario, but the reality of our changing planet. While flawed models are a problem anywhere, they are insidious when they infiltrate banks’ decision-making because of the knock-on effects across entire economies. The sooner the banking sector internalises climate risks in its decision-making, the better chance we have at building a better future.
[1] An investor-led framework of pilot indicators to assess banks on the transition to net zero, IIGCC, July 2022
[2] Network for Greening the Financial System, June 2022
[3] NGFS Scenarios for Central Banks and Supervisors, September 2022
[4] Institute and Faculty of Actuaries and University of Exeter: The Emperor’s New Climate Scenarios, July 2023
[5] European Central Bank Banking Supervision, 2022 climate risk stress test, July 2022
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