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- Firm
- Provisional
- Coming soon
- Revised
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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 & 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.
Tracking 41 countries, we find that most have initiated regular financial stress testing of bank balance sheets to check they are resilient, with a few taking the next step of including environmental standards and exposure to climate or disaster risk in their frameworks. However, gold standard incorporation of social and human rights standards into stress testing frameworks and alignment with SDG delivery remains a step too far, holding back full accountability for the finance sector.
With a high carbon legacy behind it, the UK is attempting to take a leadership role as the first country globally to adopt mandatory climate stress testing. The Bank of England’s landmark Climate Biennial Exploratory Scenario covers three climate scenarios spanning 60 years, and assesses physical, transition and litigation climate-related risks, making it the most comprehensive to date.
EU countries such as France, Spain, Italy and Germany follow closely behind, with the European Central Bank launching annual supervisory climate risk stress tests for financial institutions from 2022 onwards, and pledging to limit the amount of carbon intensive assets banks can use as collateral when borrowing from it.
Alongside strong language on the need for macro-prudential regulation to better manage environmental systemic risk in European financial centres, policy innovation is coming just as strongly from small financial hubs. Countries like Trinidad & Tobago, Bangladesh and Barbados, all severely exposed to climate risks, are making clear commitments to mainstream environmental disasters into financial stress testing. Barbados is pushing for even broader reforms of the global financial system, including revising the lending terms between international financial institutions and “frontier countries” impacted by climate change. As part of the Bridgetown Initiative, initially launched at COP26, Barbados has proposed that development banks adopt natural disaster clauses which would stipulate the suspension of interest rate payments on debt owned by the country during a disaster.
Elsewhere, adoption of climate stress testing is underway in South Korea and Brazil with consultations, pilot testing and model development in progress. South Korea has launched a newly developed climate stress test model and is in the process of designing a climate risk oversight plan, laying out a regular stress testing schedule for the country’s financial institutions. Meanwhile Brazil’s newly independent central bank is strengthening its classifications of social and environmental risk in banking regulation, and looks set to gradually introduce climate stress testing for the country’s largest banks.
These actions are promising, but not ambitious enough to mitigate the impacts of climate change on price and financial stability. With the above exceptions, most financial institutions have retained narrow mandates, committed to the carbon intensive idea of market neutrality - preferring climate scenario analysis to action.
For example, the USA has so far refrained from adopting any climate-related or environmental indicators within its financial testing framework - a notable laggard amongst its peers. And China has incorporated a few isolated environmental indicators within existing credit stress tests, while pledging to continue its “climate-related examination of the financial sector” through repetition of exploratory scenario analysis exercises – with no indication of intent to take the findings further.
We need to make finance serve society, and ensure banks are safe, green, and accountable.
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