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Editor's note: We will soon be updating our policy comparisons and case studies to include our 12 newest countries: Germany, Serbia, South Korea, USA, Ethiopia, Australia, Spain, Italy, Nigeria, Turkey, Indonesia, Japan.
Having a safe and reliable banking system is a vital foundation for any country’s economy. Banks and other financial institutions help to channel money through the economy, and match those that want to save with those that need credit or investment. Ensuring there are Safe and accountable banks who are responsible and sustainable is an important task for financial regulators.
Policies for making finance safer and more resilient - including to environmental threats - are increasingly common around the world since the global financial crisis. All 20 countries tracked so far have started some 'stress testing' of bank balance sheets to check they are resilient, with a few exploring the next step of including environmental standards and exposure to climate or disaster risk in their frameworks. Incorporation of social and human rights standards into stress testing frameworks remains a step too far, holding back full accountability for the finance sector.
Despite strong language on the need for macroprudential regulation to better manage environmental systemic risk in global financial centres in North America and especially Europe, policy innovation is coming just as strongly from small financial hubs. Countries like Bangladesh and Trinidad & Tobago, both severely exposed to climate risks, are making clear commitments to mainstream environmental disasters into financial stress testing. Meanwhile, China’s financial stability reporting now includes some environmental indicators - high pollution and high energy consumption - in credit stress testing.
About this policy
Ensure that banks and financial actors are safely serving society by subjecting them to financial, environmental, and social stress tests (e.g. not too big to fail, ethical investments, transparent & accountable to customers).
Banking resilience has become a global priority since the 2008 financial crisis, when many bank’s weak balance sheets and risky investments left the entire system dangerously exposed. Climate change and environmental risks are relevant here, because investments in fossil fuels have the potential to be just as risky as sub-prime mortgages were in 2008. Some assets which are currently valuable – such as coal mines or shale fields – may find themselves rendered worthless by stronger green policies, thus becoming “stranded” and in need of writing off. Banks that are exposed to this “carbon bubble” are a risk to the wider economy, and governments need to take preventative action.
The most basic policy approach is ‘stress testing’, where regulators assess how vulnerable banks might be to a hypothetical financial crisis – such as a deep recession or market crunch – and check for systemic risk in the banking system. More ambitious approaches expand on mere financial criteria to test banks for exposure to environmental risks – such as climate disasters – as well as assets that might be stranded by new environmental laws. The most comprehensive approaches will look even further into social stress testing, and check compliance with human rights and transparency requirements.
Case Study: Bangladesh
Bangladesh Bank’s Guidelines on Environmental & Social Risk Management (ESRM) for banks and financial institutions explicitly ask for periodic reporting on the environmental and social performance of transactions, as part of a set of “measures taken to reduce overall exposure to environmental and social risk”. Unfortunately, the environmental focus in regulations is somewhat narrowly targeted at environmental disasters (floods, earthquakes) and has not yet culminated in mainstreaming of sustainability criteria more broadly. It is also not clear how tightly financial actors are required to comply with recommended social and environmental standards.
Case Study: Trinidad & Tobago
As part of annual financial stability reporting, the Central Bank of Trinidad and Tobago incorporated stress testing of the “impacts of a climate change related environmental event on the financial system” into its 2017 FSR report. This considered the effects of an environmental shock on both the local economy – through a local natural disaster, loss of life, property damage, and reduced economic activity – alongside implementation of stronger climate-related policies, and repricing of carbon intensive and environmentally unsustainable assets.Trinidad & Tobago Country Profile