The Role of Banking in Climate Change

The fossil fuel and timber industries, two of the leading drivers of climate change, have been able to operate and expand in part through the participation of the banking sector.

To stay within the 2°C goal outlined in the Paris Agreement, the world will need to move towards net-zero emissions as quickly as possible and protect tropical forests that are essential to maintaining the climate. Despite the imperative to prepare for a low-carbon economy, banks and other financial institutions have continued to lend to, invest in, and underwrite the industries fueling climate change.

While fossil fuel companies and deforestation-linked companies are the primary drivers of climate change, most companies in these industries could not operate without support from major financial institutions. Banks provide loans that allow these companies to expand, and investment banks also provide underwriting services that help companies to issue new stocks and obtain debt financing through corporate bonds.

In the five years since the Paris Agreement was signed, the world’s 60 largest commercial banks have provided more than USD 3.8 trillion for fossil fuels through lending and underwriting. Since the Paris Agreement was signed, financial institutions have also increased their funding for commodities linked to deforestation by 40%, providing USD 153.9 billion in financing for forest-risk commodities.

Financial institutions are also major investors in these two industries. Asset managers like BlackRock and Vanguard, or the asset management arms of banks like JP Morgan and Bank of America, help large investors, including corporations and pension funds, manage and invest their money. Between 2016 and 2018, asset managers increased their investments in fossil fuels by 20%. In 2019, the three largest asset managers held a combined USD 300 billion in fossil fuel investments. In 2020, they also held USD 12 billion in investments in agribusiness companies linked to deforestation.

The industries driving climate change, such as fossil fuels, also depend heavily on insurance companies, as most oil, gas and coal infrastructure cannot operate without insurance. The oil and gas property and casualty insurance market is estimated at USD 17.3 billion, with U.S. insurance companies possessing the largest underwriting share. In addition to the underwriting services that they provide, insurance companies are the second largest investors in fossil fuels. In 2016, insurance companies held investments worth USD 221 in oil and gas companies and almost USD 2 billion in coal companies.

By continuing to finance fossil fuel expansion and deforestation, financial institutions are increasing their exposure to new, climate-related financial risks. As the world seeks to meet the goals of the Paris Agreement, a wide range of financial assets will be impacted by “transition risks,” losses due to changes in law, policy, technology and markets related to the transition to a low-carbon economy.

As climate change intensifies, financial institutions will also face risks from the physical impacts of climate change such as extreme weather and rising sea levels. Extreme weather and rising sea levels could drive down the value of property held as collateral by banks, leading to a higher probability of borrowers defaulting on loans.

Banks, insurers and other financial institutions that are heavily invested in these industries, or industries that depend on fossil fuels such as transportation, may not be able to withstand the stresses of simultaneous company failures. An assessment of loan portfolios by the sustainability nonprofit Ceres found that more than half of syndicated lending of major U.S. banks is exposed to climate risk. According to Ceres, banks “have an imperative to disclose these risks, which could subject them to major lending losses in the event of a sudden and dramatic change in public, regulatory, or investor sentiment.”

These risks could also be transferred throughout the financial system. Through a process known as securitization, banks bundle loans and indirectly issue them as securities. As climate change begins to impact the assets that underly the loans, such as mortgages in flood-prone areas, this will create new risks for these securities.

The extensive and interconnected nature of climate-related risks mean that climate change presents a systemic risk, a risk that threatens the stability of financial markets. Transitioning to a low-carbon economy in time to meet the goals of the Paris Agreement will require a significant reallocation of capital. Without sufficient oversight and risk management, a poorly managed transition could lead to stranded assets and trillions in losses in the fossil fuel industry and tens of trillions of losses across the entire industrial sector, potentially triggering a recession.

Banks can also contribute to the climate crisis when they profit from money laundering and illicit finance. This is why NWC is currently working to strengthen whistleblower laws that could be used to combat money laundering in both the U.S. and Europe. Learn more about that work here.

The Need for Stronger Oversight of Climate Risks at Banks and Financial Institutions

Banks and other financial institutions are aware of the risks climate change could pose. In 2020, a leaked report from JP Morgan stated that the climate crisis could lead to “catastrophic outcomes where life as we know it is threatened.”

Several major banks have acknowledged that they are beginning to collect data on physical climate risks in relation to mortgages. Several banks have announced their intention to become “net zero,” some have announced new restrictions on fossil fuel financing, and others have introduced “sustainable” index funds.

Voluntary efforts by banks and other financial institutions, however, will be insufficient to address climate risk in the banking and finance industry. Many of these claims deserve serious skepticism and concerned investors have begun to challenge claims that are vague, misleading, or riddled with loopholes.

Major banks have also demonstrated that, without strict oversight, they are not likely to manage existing risks well on their own. According to Better Markets, the six largest Wall Street Banks, JP Morgan, Citi, Wells Fargo, Bank of America, Goldman Sachs, and Morgan Stanley, have committed “hundreds of illegal acts and preyed upon and ripped off countless Main Street Americans with a frequency and severity that shocks the conscience.” These actions include 350 major legal actions that have resulted in almost $200 billion in fines and settlements.

The systemic nature of risk also means that firm-level risk management is not sufficient to manage the overall risk. To address climate change as a systemic risk, a coalition of central banks, called the Network for Greening the Financial System (NGFS), formed in 2017. The NGFS provides a platform for central banks and supervisory authorities to develop common strategies for sizing macroeconomic and systemic climate risks, for developing disclosure practices and evaluating credit risks, and for determining how to integrate climate into their monitoring activities.

A key feature of initiatives to address bank risk is the introduction of bank stress tests that address climate-related scenarios. Bank stress tests are designed to evaluate how a bank would be affected by various adverse market conditions, such as a housing market crash or a sudden rise in unemployment. New scenarios are selected regularly, and climate-related adverse conditions could be integrated into existing stress test requirements. In the United States, two types of stress tests are currently required.

The Comprehensive Capital Analysis and Review is an annual exercise by the Federal Reserve designed to “assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress and that they have robust, forward-looking capital-planning processes that account for their unique risks.” Bank holding companies are required to submit a capital action plan for the next four quarters, and the Federal Reserve evaluates and scores the bank’s plan.

Banks with more than USD 250 billion in assets are also required to perform company-run Dodd-Frank Act stress tests either annually or biannually. These stress tests are based on scenarios provided by the Federal Reserve. Banks are required to report the results to the Federal Reserve, and the Federal Reserve then releases the results to the public.

Central banks in the NGFS have begun to take new steps to introduce climate-related stress tests. The Dutch Central Bank has been carrying out climate stress tests since 2017. The Bank of England has made plans to conduct climate stress tests on banks in 2021 and has already incorporated climate scenarios in its stress tests of insurance firms. France, Norway, and the European Central Bank have also taken steps to address climate risk through stress tests.

The U.S. has lagged behind in recognizing the systemic risk of climate change and urgent action is needed. A report by the Senate Democrats Special Committee on the Climate Crisis, found that “[c]limate-related financial risks are systemic, and if left unchecked, could destabilize our financial markets and economy. Our financial regulators’ job is to ensure a stable and efficient financial system, which means they need to start assessing and managing climate risks.”

Testifying before the Special Committee, Sarah Bloom Raskin, a former member of the Federal Reserve Board of Governors and Deputy Treasury Secretary, stated that “[m]inimizing both physical risks and transition risks is well within the Federal Reserve’s mandate; the Federal Reserve should use its oversight authority to ensure a prudent transition to a low-carbon economy, a transition that does not destabilize the financial system.”

In September 2020, Commodity Futures Trading Commission published a widely-praised report encouraging financial regulators to consider the risks that climate change poses to the U.S. financial system. Janet Yellen, President Biden’s nominee for Treasury Secretary, has called climate change an “existential threat to the U.S. economy” and said she would create a new senior Treasury post dedicated to addressing climate change.

In November 2020, the U.S. Federal Reserve acknowledged that climate change is a potential threat to the stability of the financial system and became one of the last large central banks to join the Network for Greening the Financial System in December 2020. The Federal Reserves has also created two new committee to address climate risk: the Supervision Climate Committee (SCC), which will examine how climate change affects individual banks, and the Financial Stability Climate Committee (FSCC), which will address climate-related risks on a macroprudential level. While these moves represent encouraging steps in the right direction, more can be done.

You can learn more about the work that NWC is doing to strengthen oversight in banking here.

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