Climate risk test asks banks to look too far
Bankers have shown this year they can handle a largely destructive health pandemic that has blinded the world. But they are also preparing for another headwind: climate change.
As key financial intermediaries, banks have an important role to play in managing a shift away from carbon, but there’s one idea that doesn’t seem ready for prime time: stress tests for climate change.
Fortunately, US banks are fully engaged in assessing and disclosing climate risks. And perhaps more importantly, seeking to develop markets to help transition carbon-intensive businesses.
For example, the Partnership for Carbon Accounting Financials recently announced a global standard to enable banks, asset managers and investors to use a common method of reporting greenhouse gas emissions related to loan and investment portfolios.
Financial innovation is also underway as 2019 saw a record green bond issue over $ 250 billion, and the development of securities backed by green assets, hedging products and carbon offset market reforms. In terms of risk management, banks are actively developing their climate scenario analysis capacities to understand the risks they face in all of their activities.
But some regulators suggested go further in an attempt to quantify these risks for capital purposes using government-run climate stress tests. These tests are accompanied by hypotheses on the evolution of the climate, the evolution of government policy and the impact of both on bank borrowers. These are very difficult projections to make and can become highly speculative in the long run.
As a perspective, consider that in 2008, when the United States was a major importer of oil and natural gas, it was universally expected that it would face higher prices for the former and a shortage for the former. second. Ten years later, the United States was the world’s largest producer of oil and natural gas, the world’s largest exporter of natural gas and among the top three exporters of oil.
Remarkably, climatic stress tests in the UK and Europe envisage a period of 30 years projection with built-in assumptions on how global energy markets will develop over this period. For the perspective (and humility), consider the Federal Reserve’s financial stress tests to have a time horizon of two to three years, even in an area with a much richer history and data to support projections.
The even bigger challenge, however, is predicting how banks will change their business over that same time frame. The weighted average maturity of a commercial and industrial loan being three years, the portfolio of a bank would turn more than 10 times in a 30-year stress horizon. Of course, as climate change darkens the outlook for any given industry or business, the bank would seize any of these ten opportunities to reduce its exposure and lend to a business whose outlook has improved.
Here is an example. Suppose a US bank has a revolving line of credit to Ford Motor Co. Most predict that the climate change risk of this loan is relatively low because the bank may decide to terminate it if gasoline vehicles of Ford are losing market share over the years. . It is also possible that Ford will increase its production of electric vehicles. And of course, the bank could also cover the risk by also lending to Tesla or buying credit insurance on Ford.
So what does a bank have to assume for the next 30 years? The UK test would require a bank to model cash flows and collateral values over the next 30 years, reflecting “judgments about how companies be positioned in light of their underlying risks and opportunities, including an assessment of their current mitigation and adaptation plans.
But what can that mean? And how relevant is such an analysis when a bank has the option of simply opting out of credit at several intervals along the way? And that’s just the credit offer.
Presumably, carbon-intensive businesses that start to perform poorly will shrink, reducing their demand. for credit, and therefore the exposure of banks to any subsequent default. Weather stress tests don’t seem to take this factor – roughly half the equation – into account.
Certainly, it’s important for bankers and their regulators to measure and manage climate-related financial risk in a way that gives an accurate picture of what’s at stake. But trying to capture the effects of climate change decades to years. advance – regardless of the extraordinary adaptability of the financial system and the economy – and integrating these findings into the regulatory capital framework is no easier than predicting how pandemics or machine learning will affect banks by 2050.
Rather, regulators should ensure that climate risks are understood and disclosed appropriately. They should encourage the innovative efforts of financial companies to develop markets that can smoothly accelerate a transition to a greener economy.
Beyond finance, policy makers managing a transition to a green economy have much more effective tools, such as direct regulation or through market mechanisms. Stress testing for banks, however, appears to be a very inefficient vehicle and risks degrading the integrity of financial regulation.