Bridging the Disconnects – From Diagnosis to Action in Addressing Climate-Related Financial Risks

This article was first published on Green Central Banking here.

When the Financial Stability Oversight Council (FSOC) published its Report on Climate-Related Financial Risk last week, it triggered a wide range of reactions. Some praised it as a critical step in moving climate risks up the agenda amongst FSOC members such as the US Treasury, the Federal Reserve, and the Office of the Comptroller of the Currency. Others voiced disappointment and criticized what they perceived was a missed opportunity to make climate risks an integral consideration among US financial regulators and supervisors.

Regardless of where one lands on this, one thing is clear: the disconnects between the diagnosis of the challenge and the lack of action are significant. We may disagree on why these disconnects are there and how quickly they can be bridged, but they are vast and alarming – not just in the FSOC report, but around the world.

As Janet Yellen, Secretary of the US Treasury and FSOC Chair, highlighted in her remarks accompanying the report’s release, “we know that climate change has already started causing an array of economic harms, and failure to address climate-related financial risks will only allow them to grow larger.”

Yet, much of the measures the FSOC has put forward are centered on diagnosis rather than taking action. Filling data gaps, building capacity to assess risks, improving disclosure, and enhancing reporting are important building blocks for constant improvements in our understanding of the risks financial markets face and how to address them. However, as the FSOC report recognizes, “the need for better data and tools cannot justify inaction, as climate-related financial risks will become more acute if not addressed promptly.”

Adjusting Capital Requirements

Against this background, moving beyond diagnosis, and translating the insights we already have into regulatory and supervisory measures is critical and urgent. Reflecting climate risk assessments in capital requirements is a vital step in this direction – both on a microprudential level as well as through the use of macroprudential tools, such as systemic risk buffers. Available risk metrics are robust enough to take this step. The diversity between existing climate risk metrics is no counter to that. In fact, given the complexity in assessing climate risks, a certain level of diversity is a feature, not a bug.

Financial institutions and, crucially, their investors should support this move, and thus close the current gap between their acknowledgement of the emerging threat from climate change and the pushback of the industry against regulatory and supervisory action. Banks claim that they are accounting for climate risks in their lending decisions; insurance firms state that they are reflecting climate risks in their underwriting; asset managers offer investment funds as being aligned with climate risk considerations; and all of them thus assert that the climate risk metrics they use are indeed decision-useful. The position that financial authorities should limit their use of these same metrics to diagnosis and refrain from integrating them into regulatory and supervisory decisions is untenable.

Aligning Monetary Policy

Moving beyond diagnosis towards action is equally critical in other domains of financial governance. Monetary policy is a case in point. In March, the Bank of England committed to adjusting its Corporate Bond Purchase Scheme by the end of the year to reflect the climate impact of the issuers of the bonds it invests in. In May, it published an outline of the options it considers for doing so. In July, the European Central Bank released its action plan to include climate change considerations in its monetary policy strategy. Shortly thereafter, the Bank of Japan announced the introduction of a targeted refinancing line to support private sector lending towards addressing climate change.

While the FSOC report is focused on the regulatory and supervisory levers across its members and thus remains mute on monetary policy, the White House Roadmap to Build a Climate-Resilient Economy, published a week earlier in response to the same Executive Order from the Biden Administration, calls for a “whole-of-government effort” to address climate-related financial risks. Monetary policy must not be carved out from this imperative.

Two priorities stand out in this context.

First, like any other central bank, the Federal Reserve has a fiduciary duty to protect its balance sheet from financial risks. Accounting for climate-related financial risks is an integral part of that. Specifically, whenever the Federal Reserve sets thresholds to shield itself against financial risks – either in relation to the counterparties it engages with, or the assets it purchases or accepts as collateral – climate risks must be an integrated component in the risk assessments that underpin its operations. To the extent the Fed uses external credit ratings for these assessments, and given the concerns, also among its peers in the Central Banks and Supervisors Network for Greening the Financial System, that climate risks are not yet sufficiently accounted for in current ratings, adding further climate-related analytics is essential for that. The Fed’s reliance on external credit ratings in the context of several of its lending facilities last year is a case in point.

In addition, like many other central banks, the Fed has several options to offer targeted funding – a monetary policy instrument that has grown significantly in use over the last years across the world. The ECB’s Targeted Longer-Term Refinancing Operations (TLTROs) to fund loans to non-financial corporations and households (excluding mortgages), and the Bank of England’s Funding for Lending Scheme (with additional incentives for loans to small and medium-sized companies) provide illustrations. The recent announcement by the Bank of Japan of a targeted refinancing line for loans to address climate change offers a further example – and an illustration for the alignment of such targeting with the objective of mitigating climate risks. Exploring the possibility of such alignments through the monetary policy toolkit of the Fed – e.g., through a dedicated additional credit program in its discount window and targeted lending facilities – is critical.

Time to Act

Six years have passed since then-Bank of England Governor Mark Carney gave a key speech on the threats that climate change pose to financial stability highlighting that “while there is still time to act, the window of opportunity is finite and shrinking”. This window has been shrinking ever since. As ECB Executive Board Member Frank Elderson underlined in his speech last week, “the time for preparations is over and the time for action is now.”