Regulatory orthodoxy and the hunt for climate risk differentials

Regulatory orthodoxy and the hunt for climate risk differentials

June 9, 2022

Prudential frameworks are ill-suited to weighing the relative risks of green and non-green assets

Bankers are floundering in their search for climate risk differentials — the great white whale of climate finance. Finding these differentials could help justify the introduction of ‘green supporting factors’ (GSF), which lower capital requirements for climate-friendly assets, and ‘brown penalizing factors’ (BPF), which raise them for climate-harming ones. Supporters say these would help redirect bank finance away from climate-wrecking activities and toward low-carbon, sustainable enterprises.

The hunt hasn’t turned up much to date, according to financial authorities. A recent paper by the Network for Greening the Financial System (NGFS), the club of climate-focused central banks and supervisors, said there was little proof that climate risk differentials exist. The European Banking Authority (EBA) said similar, writing in a discussion paper on the role of environmental risk in the prudential framework that current evidence is scarce.

However, these papers focused on ex-post climate risk differentials. That is, they covered efforts to gauge the relative riskiness of green and non-green assets using pastdata. Climate finance experts say this is the wrong approach. Ilmi Granoff, until recently the Senior Director of the finance program at the ClimateWorks Foundation, a US-based climate finance charity, says banks and their regulators should use forward-looking approaches, which could better capture the variegated risks of green and non-green assets:

“The fact that backward-looking data didn’t reveal much in the way of a risk differential, I call that a ‘nothing burger.’ It’s obvious that climate risk is greater in the future than in the past and therefore isn’t fully reflected in historical data”

By this logic, regulators are tying themselves in knots straining for ex-post climate risk differentials when their focus should be on the future. Many financial institutions are already looking ahead. For instance, the NGFS found that 63% of organizations surveyed already have, or plan to introduce, forward-looking risk assessment methodologies, like climate stress tests, scenario analyses, or sensitivity analyses, which may be able to identify ex-ante climate risk differentials.

Why is the search for clear, quantifiable climate risk differentials so important to efforts to introduce GSF/BPF? The answer lies with (most) regulators’ specific understanding of how risk-based prudential frameworks should operate. Put simply, regulatory orthodoxy holds that a bank’s capital requirements should be sized in accordance with the risks it takes on. This sounds fair, but hinges on how ‘risk’ is defined and how it’s calculated.

Here’s how Dorota Siwek, Head of the ESG Risks Unit at the EBA, describes the issues with GSF/BPF:

“First of all, they would not recognize true risk, because what is green is not necessarily less risky. On the other hand, you have those established industries that are considered polluting, but they have a very good financial standing, and perhaps they also have very good transition plans to account for potential transition risks. So it’s not really accurate to say what is green is less risky than what is brown”

Clearly, this argument rests on what is considered “true risk”, which is a contested concept when it comes to climate change. As the EBA discussion paper itself notes, the current prudential framework has been built on backward-looking risk assessments, using ex-post data, which “does not align well” with the forward-looking nature of climate risks. 

Though it may be uncomfortable for financial authorities to admit, there is deep uncertainty over when or where specific climate threats to the banking system and the wider economy will materialize. This means that “true risk” in the context of climate change may be incapable of being captured using the existing prudential framework, and may never be quantifiable to a level of precision and granularity that makes authorities comfortable introducing GSF/BPF — so long as they keep to regulatory orthodoxy.

Says Granoff:

“The backward-looking tools that we have are crude tools for this task. The forward-looking nature of climate risk creates an empiricism problem, so we have to use modeled data instead of historical data. At the same time there is uncertainty as to the magnitude and nature of climate risks in the future. We have to be careful, then, using quantified risk as the only basis for risk-weighting. It’s not appropriate for regulators to ignore uncertainty in their approach”

The EBA is not completely blind to this tension between risk and uncertainty. In its discussion paper, the regulator says that uncertainty over how climate risks translate into financial risks over time “will have implications for the extent to which the Pillar 1 framework allows automatic capture of such risk, absent legislative amendment.” 

In this statement there is a nod to a second piece of regulatory orthodoxy — a belief that the makeup of prudential frameworks should naturally allow climate risk differentials to surface. Specifically, the EBA paper argues that climate-related risk drivers can be captured by the existing prudential framework through certain “mechanisms” that feed into Pillar 1 requirements. (Pillar 1 requirements are the minimum regulatory capital charges that apply to all banks). These “mechanisms” take data inputs — including external credit ratings, collateral valuations, financial instrument valuations, and the findings of banks’ internal risk models — to calculate Pillar 1 charges for different kinds of exposures. 

What’s odd about this viewpoint is that it shifts responsibility for capturing climate risk differentials from financial authorities to entities beyond their direct control. External credit ratings are assigned by credit rating agencies, not regulators. Collateral and financial instrument valuations are determined by markets and/or estimates cooked up by banks themselves. Internal models, of course, are developed by banks’ own risk modeling teams.

It’s not clear why this outsourcing would allow for the “automatic capture” of climate risk differentials, either. After all, other entities are struggling with all the same issues as the EBA, says Julia Symon, Head of Research and Advocacy at the EU think tank Finance Watch:

“All the pieces that they refer to face the same challenges as a recalibration of Pillar 1 has. They have the same challenges with the data, with the methodologies, with segmenting and defining those exposures subject to differentiated capital treatment. They also rely on past data”

Furthermore, the evidence that these “mechanisms” are working at all in the context of climate risk is mixed. Take credit rating agencies. The NGFS recently reported that they face limitations fully capturing these environmental risks in their methodologies. As for firms’ internal models, the European Central Bank said last year that just 8% of banks assess the impacts of climate and environmental risks on their capital adequacy. This suggests that at least some of these “mechanisms” are doing a poor job conveying climate risk into Pillar 1 requirements so far. However, the EBA’s Siwek argues that they will reflect environmental factors to a greater extent over time.

There’s a third piece of regulatory orthodoxy standing in the way of GSF/BPF. This is a belief among regulators that they, and the rules they develop, should be apolitical. “We really do not think that the prudential framework should be a tool for public policy,” says the EBA’s Siwek. For justification, she points to the European Union’s small and medium-sized enterprise (SME) supporting factor, a politically inspired change to the bloc’s capital rules. Says Siwek:

“The SME supporting factor is an example of a tool that is incorporated for political objectives rather than for the purpose of improving the prudential framework. We also see that it did not have the effect assumed. Not only is it not risk-based, it does not bring this additional credit to SMEs as policymakers were hoping for. So I think here we could draw parallels to potential green supporting factors, which would not necessarily lead to increased lending towards green investments, because there’s a lot of other factors at play

There’s a few problems with the idea that regulators can be apolitical, though. First, it downplays how banks and their regulators shape, and are shaped by, public policy. After all, banks are important transmitters of monetary policy and central banks’ efforts to manage financial conditions. Furthermore, what banks choose to invest in and who they choose to lend to is influenced by regulation (and attempts to get around regulation) which is itself a tool of government policy.

Second, by telegraphing how much they do not want to appear to be political actors, authorities invite bad faith attacks from anti-regulatory interests which can claim that any change to the prudential framework they don’t like is politicized. Says Granoff: 

“It makes sense to have supervisory authorities that are independent and technocratic — but they’re still taking policy decisions. We don’t want to be in a situation where industries that happen to be disfavored because they create climate risks can chill prudential regulation on the accusation that it’s political”

Third and finally, it privileges the technocratic reputations of regulators over their responsibilities to take action against looming threats to the banking system — whether or not those actions are popular. Science shows climate change is an existential threat to humanity. That makes it an existential threat to the banking system. The question is not whether regulators will respond or not — it’s whether they will respond with boldness or timidity. Time matters here, too. The longer they respond with timidity, the bolder they’ll have to be in the future.

GSF/BPF may be, in Siwek’s words, a “crude simplification.” But they represent a clear effort to get the prudential framework to explicitly recognize climate risk, instead of trusting that the current system will implicitly capture a growing threat that it was not built to address. As Symons says:

“The framework has to evolve — the fact that you can’t put all the familiar labels and tags on climate-related risks to fit them into well-known methodological frameworks should not be a reason not to do something. Unlike other known financial risks, climate-related risks grow with time at the systemic level unless actions beyond exploration are taken”