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Sustainable finance and the latest banking regulations

17 February, 2020Paul Fisher

Paul Fisher looks at how banking regulators are developing new rules and implementing policies to curb emissions.

Wind turbines on a green hillIn Paris 2015, 197 signatories from governments and international organisations promised to take action to limit global warming to no more than 2OC with an ambition to limit it to +1.5OC. 

Initially there was little indication of what they would actually do to meet those commitments. 

Now the fog is beginning to clear – in some parts faster than others. In particular, banking regulators around the world are getting organised and implementing new policies.

The UK is one of the leaders, and a founder member of the Network for Greening the Financial System (NGFS). This is a group of 54 central banks and regulators who are co-ordinating on policy and implementation. 

This ‘coalition of the willing’ isn’t happening under the auspices of the Basel Committee on Banking Supervision (BCBS) which has never operated with a sense of urgency. But the policies emerging so far are consistent with the Basel regime.

Banking regulation

There are three pillars of banking regulation:

  • Pillar I: Minimum capital requirements for everybody.
  • Pillar II: Supervisory intervention and capital requirements for risks not covered in Pillar I.
  • Pillar III: Market discipline through disclosure.

Progress is being made in reverse order.

Disclosure requirements were set out in 2017 – for all firms in the economy, not just financial firms – by the G20 FSB Task Force on Climate-related Financial Disclosures

Although tasked with setting out voluntary recommendations, the EU and the UK are both making moves to embody these recommendations in their reporting rules.

Other jurisdictions have followed the earlier French example of specific requirements under Article 173-VI of the 2015 ‘energy transition for green growth’ law. 

Either way, disclosure is the ‘low hanging fruit’ of the regulatory response to climate change.

Supervisory intervention

Pillar II is likely to be the immediate battleground. Different supervisors have different approaches to firm-level intervention. 

The Prudential Regulation Authority (PRA) at the Bank of England is showing the way. 

It has already published a set of supervisory expectations on managing climate risks and recently announced proposals for consultation on climate-stress scenarios. 

The UK has also made the management of climate risks a required function under its Senior Management Regime.  

This is probably the single most intrusive green banking regulation so far. Personal accountability has a way of concentrating minds and UK firms have had to up their game.

Market discipline through disclosure

Pillar I is one for the future.  Although some sectors of the banking industry in Europe have called for a ‘green supporting factor’ to reduce capital weights for green lending, that seems unlikely unless it can be justified empirically on a risk basis. 

As yet, we do not even have definitions for a green asset class to make a risk assessment about – although the EU is working on a green taxonomy.

And it is unlikely that green assets are less risky than current Basel weights assume. In due course, the evidence is likely to reveal more risk in brown assets.

Overall, banking regulations are intended to preserve the financial stability of the system.  That is a prerequisite for a sustainable – and green – economy in the future.

Risk-based capital requirements are a key part of that rationale and will not be used to try to direct capital on any other basis. If climate change justifies changes in capital weights on a risk basis, then that must happen of course. 

But such changes take time, which we do not have. 

There is nothing to stop supervisors using Pillar II requirements now, to the same effect, under existing Basel rules. That’s what the PRA and FCA are doing – as are regulators in other countries such as the Netherlands.

More renewable power to their elbows!

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