Obtain the data you need to make the most informed decisions by accessing our extensive portfolio of information, analytics, and expertise. Sign in to the product or service center of your choice.
The Federal Reserve Bank of New York (NY Federal Reserve) for
the first time has linked the indirect risks that climate change
poses to the banking sector.
The staff of the regional reserve bank examined the impact on
banks with loans to the oil and gas sector by using a stress test
approach that was developed in response to the 2008 global subprime
mortgage crisis.
In a recently released report, Hyeyoon Jung, Robert
Engle, and Richard Berner of the NY Federal Reserve found that the
exposure for some of these banks arising from indirect climate risk
to be "economically substantial."
"This report shows that this risk is so concentrated in the
equity of the world's largest banks that it could threaten their
ability to retain prudential capital reserves, and in turn limit
their ability to withstand financial shocks that could threaten
global financial stability as a whole," IHS Markit CleanTech and
Climate Executive Director Peter Gardett told Net-Zero Business
Daily.
The staff reached this conclusion after measuring climate risk
in 27 large global banks in the UK, US, Canada, Japan, and France
that together hold more than 80% of the syndicated loans made to
the oil and gas industry.
No course of action recommended
Their report, however, stopped short of recommending any course
of action for the US Federal Reserve Board, which plans to include climate change
risk as part of its framework to assess the financial stability of
banks that it oversees, and is in the throes of completing a
study.
The report also didn't evaluate the direct physical climate risk
to banks, but said the same approach could be applied.
The inclusion of climate risk into the central bank's
assessments will take place after the Fed completes its study of
the vulnerabilities that financial institutions potentially face
"both from the consequences of climate change and the policies
designed to mitigate that effect."
The report's findings are significant because they give an
indication of a climate-stress test approach the NY Federal Reserve
is taking seriously enough to release it publicly, Gardett
said.
Increased exposure
Banks that provide financing to firms that extract or use fossil
fuels are expected to see an increase in their exposure when the
default risk of their loan portfolios rises as economies transition
to a lower-carbon environment, according to the paper.
There is no question that "climate change poses a considerable
risk to the financial system," if banks systemically suffer
substantial losses following an abrupt rise in the physical risks
posed by climate-fueled hurricanes or wildfires that result in
destruction of homes and businesses, or transition risks, it
added.
The NY Federal Reserve report authors set out to discover how
resilient financial systems were to climate-related risk by
measuring "CRISK," the expected impact on a bank's capital during a
climate stress scenario. The authors measured it by making a
climate-based update to a systemic risk calculation, or "SRISK,"
that a group of economists developed a decade earlier to measure
the resiliency of banks after the global financial crisis.
According to Gardett, they examined the impact of the fossil
fuel asset repricing exposure as a result of climate impacts across
each bank's debt position, across the change in climate risk
position in order to account for the long-run marginal expected
shortfall in repayments, and across each bank's equity expressed as
its market capitalization.
Decline in market capitalization
The report's calculations show it is the decline in market
capitalization that "most swiftly and damagingly" boosts climate
risk, putting the bank's prudential capital ratio position at risk,
Gardett said.
Prudential ratios are used by banks and their regulators to
monitor and determine the stability of banks' finances. These
include free capital, capital adequacy, and liquidation ratios,
which determine a debtor's ability to pay off current debt
obligations without raising external capital.
While the paper measured CRISK between 2000 and 2020 for the 27
large banks, it honed in on 2020 when oil and gas prices
essentially collapsed.
That's when the paper was able to align most closely the
increase in CRISK at banks with a decrease in equity.
For instance, the paper said Citigroup's CRISK grew by $73
billion in 2020, meaning that is the amount that the bank would
have to raise in equity to restore its prudential ratio.
The paper also noted that climate risk readings for banks
started to climb in 2018 before rocketing higher in the early
months of 2020 and settling at more elevated levels.
US, French, Japanese banks most exposed
Banks in the US, France, and Japan saw the biggest rises in
CRISK measurement of the correlation between financial portfolio
repricing and their own equity during the period from 2018 onwards,
while UK and Canadian banks experienced smaller CRISK rises.
The NY Federal Reserve staff report has implications for banks
that are moving towards renewable energy as their calculations
showed lower exposure. An IHS Markit analysis of the market showed
banks and companies issued at least $175 billion in green bonds
that were fitted to investments in clean energy technology.
The International Monetary Fund, in its semi-annual Global
Financial Stability Report released 4 October, said the transition to a
net-zero carbon economy will require "unprecedented change" by
companies and governments, as well as additional investment of as
much as $20 trillion over the next two decades.
Posted 05 October 2021 by Amena Saiyid, Senior Climate and Energy Research Analyst
