No charge: industry groups sharpen opposition to prudential climate rules

February 22, 2021

No doubt about it — there’s been an awakening. US financial watchdogs largely ignored climate risks these past four years (with some notable exceptions). Now, they’re alert and appear eager to make up for lost time.

In 2021 already, the Federal Reserve has formed a new Supervision Climate Committee, the Treasury Secretary has pledged to create an in-house climate hub, and the Office of the Comptroller of the Currency has halted a rule that would have hobbled banks’ climate risk policies. 

“All social change — and climate risk work is an example — goes through different phases of development. First, it goes through an education phase, then an activation phase, and then an implementation phase. In 2020, with many of the regulators we talked to — and we talked to literally hundreds — they were in the education phase. Now we’re getting to: ‘what should we do, and how should we do it?’” says Steven Rothstein, managing director of the Accelerator for Sustainable Capital Markets at Ceres, an environmental nonprofit.

Answers to these questions are coming in thick and fast from industry trade bodies. Recent months have witnessed a flurry of papers on climate-related regulation from groups representing banks and other capital markets participants. Just last week, the US Climate Finance Working Group (CFWG) — a coalition of trade associations — published a set of principles on how to facilitate a transition to a low-carbon economy in the US. This followed a far weightier set of recommendations from the Institute of International Finance (IIF) on January 21, reflecting institutions’ thinking on climate-related regulation and oversight.

Both documents include plenty of ideas that align with those of climate advocates. Several reflect initiatives already taken up by financial institutions and their regulators — like building up climate risk modelling and scenario analysis. Others, though, read like warnings against regulatory overreach. 

This is true of one prudential tool in particular: capital charges. Trade bodies have repeatedly made plain their opposition to altering the amounts of loss-absorbing equity that firms should hold against carbon-intensive, “dirty” assets and their climate-friendly “green” counterparts. The IIF’s paper said that “regulatory capital does not have a significant role to play as better-suited tools are available”, while the CFWG principles argued that “any measures that could restrict finance to companies most in need of support for transition” — a reference to “dirty” borrowers — are “not the most appropriate means” of fulfilling climate goals. For its part, lobby group the Bank Policy Institute (BPI) said it would be “premature” to adjust capital requirements following the findings of future climate stress tests.

Capital punishment

That trade bodies are leery of climate capital charges is no big surprise. Capital put aside in a bank’s “rainy day fund” is essentially unproductive, as it can’t be used to grow assets, invest in its businesses or distribute to shareholders.

In addition, studies show that regulatory capital charges that do not align with firms’ own risk assessments often skew their behaviour: putting them off those activities with high charges, and herding them towards those with lower regulatory costs. Mortgage servicing assets offer a recent example in the US.

“It can be a very blunt tool in that regard,” says Lauren Anderson, associate general counsel for regulatory affairs at the BPI. “We’ve seen this in housing finance: mortgages have moved out of the banking sector to ‘shadow banks’ — and you can debate whether that’s desirable or not. You could have something very similar in the climate space if you penalise lending to certain companies. It’s not getting to the root issue of the problem you’re trying to solve, it’s just pushing it to someone else”.

Certain regulatory officials appear to agree that imposing climate capital charges would not make sense at this point in time. Their arguments concern the underlying data on climate risks — or more accurately, its absence. On an IIF webinar held on January 28, Zeng Yi Wong — executive director of the Monetary Authority of Singapore — said that the case of whether “dirty” and “green” assets have different risk profiles has yet to be proven, referencing a 2020 study by the Network for Greening the Financial System (NGFS).

“If there is a consistent linkage between a particular type of assets and higher default rates, this should prompt financial institutions holding such assets to put in place more robust measures to mitigate the potential default risk. The study did not view conclusive evidence on the existence of a risk differential between green and other assets,” said Wong, who also chairs the NGFS’ microprudential and supervision workstream.

Without hard data, any hypothetical climate capital charges would have to depend on supervisory judgements, which by their very nature are subjective. Some fear that forging ahead this way could undermine the credibility of existing capital frameworks.

“The integrity of the prudential regime relies on it being risk-based and data driven, and if we start playing around with it we need to make sure we can support the adjustments we are making with verifiable analysis,” said Chris Faint, head of climate and small mutuals at the Bank of England, on the same IIF webinar.

Data and risk-based rationales alone, though, do not have sole sway over the capital-setting process. Politics often has a role to play, too.

European policymakers, for example, included a small and medium-sized enterprises (SME) supporting factor within their capital rules, which reduces the charges applied to loans to qualifying businesses, nowithstanding their underlying risks. Europe’s own banking authority wrote in 2012 that it did not find enough evidence to support this reduction. And in the US, prudential regulators “gold-plated” the internationally-agreed capital framework for too-big-to-fail banks, something Wall Street executives grouse about to this day.

Politics played a part in both decisions. It’s already part of the debate on climate-related financial regulation, too. In the US context, this would complicate any hypothetical effort to get climate capital charges on the agenda.

“Acknowledging the consensus views around climate science and the role of central banks should very much be viewed as an apolitical thing, because they’re just acknowledging what the rest of society has said about these problems,” says Graham Steele, director of the corporations and society initiative at Stanford Graduate School of Business. “But even the Federal Reserve adhering to the minimum best practices of an international consensus of central banks [by joining the NGFS] has been called ‘radical’ by certain politicians. That to me feels like the biggest blockage to the Feds’ actions right now — being viewed as a political body”.

Industry groups, for their part, want politics to take a back seat in any decisions regarding climate risk regulation. But their insistence that climate capital measures be based on empirical evidence could be just as obstructive to progress on prudential regulation. The CFWG principles, for instance, say that if policy actions “to support climate and broader ESG goals” are needed, they should be “exclusively risk-based, principles-based, predicated on robust data and well grounded, widely accepted methodologies, and integrate an ex-ante cost-benefit analysis”.

It’s quite the checklist, and one which no regulator may ever be able to fulfill. After all, climate risks are inherently forward-looking, which makes quantifying them dependent on forecasts, rather than the analysis of past events. Climate risk assessments, therefore, may never be sharply defined or expressible to a high degree of confidence.

“It is, by its nature, going to be speculative,” says Ivan Frishberg, director of impact policy at Amalgamated Bank. “But our world is full of assumptions based on market projections and historical projections that are inherently speculative. I think that’s where they [regulators] have to go with stress testing, but that’s what freaks the banks out, as [the results of these] spill back into capital requirements”.

Shadow capital charges

Data and politics are two barriers to climate capital charges. Another argument against binding ‘Pillar I’ requirements, though, is that climate risks already are being factored into the banks’ capital planning — just without the ‘climate’ label attached.

Says BPI’s Anderson: “The idea that banks are not capitalising or pricing in immediate term risk is incorrect. Large banks with diversified portfolios, they will be looking at risks like mortgage exposures in flood plains, or fire-prone areas in California, and placing a different credit risk on these than the same assets in different geographies”.

Certain banks have publicly stated they plan to incorporate the findings of internal climate stress tests into their capital planning. Barclays, for instance, said it would do so in its latest climate-related disclosure.

Some regulators too are keen to convey that just because there isn’t a formal ‘Pillar I’ climate charge on the horizon, that doesn’t mean climate risks can’t be capitalised. The BoE’s Faint, speaking on the IIF webinar, explained the UK approach: “Within the PRA [Prudential Regulation Authority] we’ve not said you have to hold capital around climate risks. But what we have said to firms is that from the beginning of next year we want to understand — in line with the broad ICAAP [Internal Capital Adequacy Assessment Process] — how firms have got themselves comfortable that there is not material climate risks that haven’t been capitalised for”. These assessments need not rely on hard data alone, Faint added, as expert judgement could stand substitute where numerical information is missing.

It’s a savvy approach. The PRA is effectively telling banks to convince them that their “rainy day fund” is sufficient to absorb losses from potential future climate events, rather than imposing a top-down requirement with all the wrangling this would entail.

Of course, the downside of this approach is that it relies on each firm’s own in-house assessment. Left to their own devices, banks may downplay their real climate exposures and in doing so misrepresent the sufficiency of their capital resources.

Pricing power

Though industry groups oppose climate capital charges in the near-term, they do support an initiative that would have roughly the same effect on investors’ capital allocation: putting a price on carbon.

The CFWG’s principles, for instance, “support the use of market-based mechanisms, including a price on carbon”. Last year, JP Morgan, Citi, and Morgan Stanley were among the institutions to endorse the Commodity Futures Trading Commission’s (CFTC) flagship report on climate-related market risks, which called for an economy-wide price on the greenhouse gas.

‘Carbon pricing’ may have many guises, but regardless of how it’s implemented the impact on bank capital requirements would likely resemble that caused by a regulator-set climate factor. A company that emits clouds of carbon would incur a greater toll through a carbon pricing mechanism than one that produces little. A “dirty” corporate would see these costs have a deleterious effect on its creditworthiness in the eyes of would-be lenders. Risk-based prudential rules would then automatically require a larger amount of capital to be put against any financing extended to the entity.

“The impact is the same thing, which is that it starts to put a price on high carbon activities where there’s debt involved. All of a sudden, it means financing $100 million of something that is high-carbon is going to cost you more than financing something $100 million that is low-carbon,” explains Frishberg. 

This being the case, why are banks and trade bodies supportive of carbon pricing while opposed to climate capital charges? One likely answer is that prudential regulators would not be able to impose a price on carbon unilaterally. As the IIF paper states, this would have to be the product of an economy-wide transformation, brought about by governments or through broad, sustained market-led support. Either way, unlike capital charges, it is not something in the gift of financial watchdogs alone.

Because of this, Steele argues that industry support of carbon pricing is simply a way to kick the question of climate capital charges into the long grass: “I think that there are a number of these situations where they’ve argued: ‘this stuff [carbon pricing] is too hard to figure out, how could we even do it, we’re just simple bankers’ — even though we know there are other situations where they hold themselves out as having the wherewithal of being able to understand a lot of complex market related risks”.

But another driver may be that a fair, methodologically-sound carbon price would eliminate the concerns about data and politics enumerated above. Instead of the hazy findings of forward-looking scenario analyses, regulators could use a carbon price to benchmark any climate capital requirements. Using an economy-wide number approved by public and private actors would also free regulators from accusations of political bias in their rulemaking.

Still, a universal carbon price remains a pipe dream, and with climate risks already manifesting, watchdogs may not be able to wait that much longer before taking action on their own — not with the safety and soundness of their supervisees at stake. This means the current agreement between industry groups and regulators that it’s too soon for climate capital charges is unlikely to last.

Indeed, it’s possible that the latter will take a more strident view in the wake of planned climates scenario analyses and other fact-finding efforts — particularly if they reveal worrying vulnerabilities. Watch this space.