How Banking Regulation can serve the Ecological Transition
& & & & & , 13 September 2022
The Paris Climate Agreement commits signatory countries to making financial flows “compatible” with its climate objectives. Fulfilling this commitment requires the profound transformation of financial flows and the financial system, something that cannot happen without proactive regulation, prepared to fully integrate transition objectives into banking rules and supervision. This note contributes to the debate on the specifics of this integration, arguing not only for prudential measures but also for structural measures, actively influencing the transformation of bank balance sheets and forming part of a more global policy mix.
As the IPCC pointed out in its April 2022 report, financial flows are currently a long way adrift of the pathway to carbon neutrality. A drastic change of direction is vital. However, the shift will not happen spontaneously; on the contrary, it requires a concerted effort by public monetary and financial authorities, central banks and supervisory authorities to “green” their actions. The former are willing to make their monetary policy frameworks greener but are still doing little. The latter are at the recommendations stage, but do not yet have any new rules to enforce. Above all, the debate on the greening of financial regulation is moving too slowly and remains too limited to the issues surrounding market transparency. So let’s put the question more directly: what would resolutely "proactive” financial regulation look like, regulation that would actively push institutions towards compliance with the Paris Climate Agreement?
This note focuses chiefly on banking regulation, its regulatory component, and how to make it a lever for the ecological transformation of the economy. Of course, all financial actors, whether banks or not, should be sensitive to climate risk. Our starting point is that consideration of climate risk by the financial sector is still inadequate and that mitigation of this risk will not progress quickly enough without regulatory pressure. As banks remain major players within the European financial system and are relatively more regulated than other financial actors, our analysis concentrates on why and how the greening of banking regulation should be implemented.
The main message of this paper is that the greening of banking regulation will need to closely combine two types of approach to be effective: the “prudential” approach through which regulators normally consider greening, but also the “structural” approach, which they will be more reluctant to take.
The greening of banking regulation provides an opportunity to strengthen two weak pillars of the current system: macroprudential regulation and structural regulation. Both are essential to the proper functioning of the banking sector, both in terms of its stability and its contribution to the financing of the economy:
- There has been too little building up of the macroprudential pillar since the financial crisis of 2007-2008;
- As for the structural pillar, it was dismantled by the financial liberalisation of the 1980s and has not been rebuilt since, even though Article 2 of the Paris Agreement (2015) specifically raised the issue of alignment between financial flows and climate goals, stressing the need to “make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development”.
This combination of macroprudential and structural approaches will only be possible if ideological barriers are removed. It involves regulators being prepared to look at the role of banking and financial regulation not only in terms of financial stability, but also in terms of the allocation of financing. To do so, they will first have to recognise trade-offs between physical risk and transition risk as part of a “risk-based approach” inevitably result in too little action, taken too slowly, allowing the ecological imbalance to continue. More fundamentally, they will also have to recognise that markets are failing not only to produce information on climate risk but also to allocate finance efficiently, taking planetary boundaries into consideration. Recognising this fact is only possible if we depart from the dominant theoretical framework based on the informational and allocative efficiency of the financial markets. This ideological dissociation is the price to be paid if banking regulation is to be overhauled and banks are to be able to help finance the ecological transition. The greening of regulation offers the opportunity for this process.
Regulators are now beginning to consider climate or ecological risk, but from a purely prudential perspective. We would like to draw regulators’ attention to the fact that a prudential approach will not be enough. More specifically, a microprudential approach based on the assessment of past individual risks will not be appropriate for climate risk, while the macroprudential approach will be necessary but insufficient.
Indeed, the “microprudential” framework, focused on the prevention of individual risks, is not appropriate for handling the systemic dimension of climate risk. If, nevertheless, the greening of banking regulation were to begin with the inclusion of climate risk in microprudential capital requirements, then—at the very least—risk weights would have to be dropped and sectoral leverage ratios used. The measurability of climate risk should not be overestimated, nor should the door be opened—any more than it already is—to the manipulation of weights by institutions permitted to use internal models.
Financial risk and climate risk share a systemic dimension, which immediately places action to mitigate climate risk at a “macroprudential” rather than “microprudential” level. As the macroprudential framework is still relatively undeveloped, some will see this as a limitation to the greening of regulation; we prefer to see it as an opportunity to deepen it. The macroprudential framework has the merit of existing and offering a transposition to climate risk that is both possible and easily identifiable by regulators. In this note, we show that one of its existing instruments, the systemic buffer, would be particularly well suited to taking climate-related systemic risk into account. This will be necessary but not sufficient.
Indeed, the greening of financial regulation needs to be done not only from the perspective of the financial risks induced by climate change and the ecological crisis, but also the problems that finance poses to climate and sustainability. In its current form, finance contributes to global warming, loss of biodiversity, pollution, and more. Faced with this dual materiality of ecological risk, the prudential framework has its limits. The greening of financial regulation cannot be restricted to this; it must also involve a structural approach.
While the prudential framework is intended to be preventive, its main aim is to ensure that banks are able to absorb shocks or even losses. Climate risk, however, is characterised by radical uncertainty and the irreversibility of its occurrence. The radical uncertainty of climate risk was highlighted in the Green Swan report (2020). It renders obsolete traditional risk management models that are backward looking and based on measurable risks. When the loss is immeasurable and unpredictable, it cannot be protected by an ex ante estimate. Moreover, the comparison between the climate crisis and the financial crisis does not hold for long. A financial crisis, if not prevented, can be “managed” to reduce its economic and social consequences and allow a controlled return to pre-crisis conditions. Climate change, on the other hand, proceeds by thresholds of irreversibility. From this point of view, the prudential logic—which, whether micro or macro, basically consists of ensuring that the actors exposed to risk are able to absorb any losses—is not well suited to climate risk. With the prospect of an irreversible climate crisis, it is not a matter of “preparing” for it financially, but of avoiding it happening and avoiding all its consequences, not only its financial consequences.
This involves concerted action across both sides of the dual materiality. It is through structural regulation targeting the composition of bank balance sheets and the direction and destination of financial flows, in addition to prudential rules which have little or no impact on the climate, that finance will reverse its impact on the climate. Through the recomposition of their assets and active participation in the financing of the ecological transition, banks will be able to protect themselves from climate risk and redirect financial flows towards sustainable pathways in the various dimensions of the ecological transition (climate change, biodiversity loss, pollution).
Much of the action will therefore impact the assets side of the balance sheet and its composition. The structure of banks’ balance sheets must change. This change cannot depend merely on voluntary commitments, which do not seem to be working. It will require “structural” measures, enabling the planned recomposition of the banks’ balance sheets. We propose a combination of:
- A flow rule to prohibit new financing of fossil fuels and guide new financing towards assets aligned with climate objectives;
- A stock rule to progressively reduce outstanding high-carbon investments;
- Alongside a public-private (or public) hive-off structure, depending on the stranding risk of assets not aligned with the objectives of a low-carbon economy, and a strong degree of conditionality in terms of alignment sought.
This recomposition of bank balance sheets will involve dealing with the problem of “stranded assets”, i.e. finding a way to progressively expel securities issued by companies in fossil, polluting or high-carbon sectors, whose value has fallen or will fall sharply. We believe there are three reasons for clearing balance sheets of this mass of stranded assets.
- The first is financial stability. Balance sheets need to be protected from the risk of financial instability arising from a destabilising pool of stranded assets.
- The second is the reorganisation of balance sheets and the necessary reorientation of banks’ business models, without the impediment of an “unnecessarily” risky balance sheet.
- The third is the removal of the brake that stranded assets on banks’ balance sheets would constitute: a bank has every incentive to continue financing non-aligned companies if it holds assets in those companies.
To clear balance sheets of these masses of stranded assets, securitisation solutions, such as those considered by the European Commission to deal with non-performing loans, or private bad banks, such as those suggested by the heads of asset management companies, will not be possible. It is not a matter of ensuring the liquidity of these assets but of no longer trading them and of accommodating them on the balance sheet of an institution that will be able to bear the loss without significant damage, while the activities associated these assets disappear or are transformed. Mixed public/private structures could be considered for assets where the risk of stranding will not be too high or will diminish rapidly following the swift alignment of business models with low-carbon objectives. But if alignment is not sufficiently rapid, it will be necessary to rely on a public hive-off solution, or even to use the central bank, which could become the “buyer of last resort of excluded assets” through a stranded asset purchase programme, executed according to a defined schedule and at necessarily low prices, determined in close collaboration with the supervisory authorities.
To avoid the moral hazard that can arise from the socialisation of losses, hive-offs will have to be subject to strict conditions:
- The divesting bank will have to reorient its future activities, completely excluding any new financing of high-carbon or polluting activities (quid pro quo) and the hive-off structure will support the reorientation of balance sheets;
- The transfer price should be low enough (significant haircut) to limit public losses and windfall effects.
This type of conditional hive-off would be doubly positive for the transition: it would lift the inertia weight of the stock of stranded assets from the banks’ balance sheets and would redirect the flow of new financing towards a low-carbon objective. Hive-offs must always go hand in hand with structural action to promote the recomposition of balance sheets.
The greening of bank balance sheets will not be possible without a common and consensual benchmark that is sufficiently granular and scalable. The taxonomy developed by the European Commission will come into force during 2022. It is still far from being consensual for reasons that include the fact that it defines “green” sectors and assets but not “brown” ones, and treats nuclear and gas as “green” or “transition” energies. It is also not granular enough and remains fairly static; a benchmark is needed that is sufficiently dynamic that it can take into account and encourage the transformation efforts of companies in all industry sectors, financial and non-financial. The public authorities will have to be heavily involved in developing this common benchmark and in the extra-financial rating system that will use it. A public agency governed by all stakeholders, which would be responsible for rating assets according to the taxonomy and for certifying banks’ carbon footprints, appears to be the best way to achieve this in a consolidated manner.
The greening of banking regulation will certainly not be an entirely smooth ride; among other impedements, it will face institutional obstacles due to the complexity of the process and the overlapping responsibilities of national and supranational authorities within the European gover-nance system of financial regulation and supervision. There is a high risk of regulatory dilution and relaxation across the poorly integrated European area, where the principles enshrined in first-level legislative acts may then be diluted or undone by delegated acts that are supposed to support the practical implementation of these principles. One can choose to see this as a serious obstacle to the effective greening of financial regulation or, conversely, as an opportunity, insofar as only a firm political will to green regulation will ward off the dangers of avoidance. There will be no choice but to assert this will, otherwise the ecological transition will fail.
Lastly, the greening of banking regulation is certainly not the only lever for ecological transition; it must be done in connection with tax, monetary and, of course, fiscal policies, the real linchpin for ecological transformation. This so-called policy mix will have to become more intense and evolve into a true climate policy mix. This new, connected approach will inevitably change the institutional framework.