Central Banks Must Heed Their Own Warnings on Climate Risks
Alexander Barkawi | 13 October 2020
Monetary, Blog | Tags: Asset Purchases, Central Banks, Climate Risk, Collateral Frameworks
The Central Banks and Supervisors Network for Greening the Financial System (NGFS), a group of more than 70 central banks and financial supervisors across the globe, has repeatedly highlighted that climate risks are financial risks. Its members have also continuously put a spotlight on the fact that these financial risks are not sufficiently accounted for – neither by banks and investors nor by the rating agencies that market participants, including central banks, rely on. As central banks rapidly expand their balance sheets, they must urgently close this gap in their risk management.
The state of affairs is alarming. The European Systemic Risk Board, which is tasked with macroprudential oversight of the EU financial system and the prevention and mitigation of systemic risk, warns that “financial market pricing of climate risks appears heterogeneous at best, and absent at worst”. Similarly, the Bank of England concluded from its last stress test of the insurance sector that there are “significant gaps in the industry’s capability to evaluate climate-related scenarios” and that “these gaps are particularly acute in relation to the evaluation of climate impacts on investments”.
These alarm bells notwithstanding, monetary policy operations remain largely oblivious to climate risks. This does not only put central bank balance sheets, and thus public money, at risk, but also their credibility as supervisors. As Andrew Bailey, the Governor of the Bank of England, emphasized, central banks sit at the heart of the financial system and must hold themselves to the same standards as the financial institutions they regulate.
The climate-related financial disclosure published by the Bank of England in June is a commendable step in this direction. It sets out the governance structures through which the Bank seeks to manage climate-related financial risks and provides an initial assessment of climate risks across all its operations, including its asset holdings. Yet, the report also highlights that the Bank falls short of the comprehensive integration of climate risk analytics into its asset purchases and collateral framework that it expects from the financial institutions it supervises.
The European Central Bank displays a similar, if not bigger, dissonance. In May, it published a draft guide on how it expects banks to manage climate-related risks. Yet, it neither accounts for these risks in its own asset purchases nor its collateral framework. Christine Lagarde, the ECB President, has repeatedly confirmed her intention to address this omission. Her colleague on the ECB Executive Board, Isabel Schnabel, as well as Jens Weidmann, the President of the Bundesbank, François Villeroy de Galhau, the Governor of the Banque de France, and further officials of Eurozone central banks have endorsed the need to do so.
Nonetheless, while the direction is clear, the speed of travel remains distressingly slow. The ECB has indicated that it is tying its next steps for climate risk integration to its strategic review for which results are expected next year. By then, the ECB balance sheet will have grown significantly. Ensuring that this expansion accounts for climate risks is imperative.
The NGFS has repeatedly highlighted the need for central banks worldwide to “assess the implications for risk management practices, as climate-related shocks may affect the riskiness of their financial portfolios and market operations”. The contradiction that central banks are identifying climate change as a key financial risk and do not act on it in their own operations is untenable. Limitations in data and analytics cannot be an excuse for inaction. Central banks have a fiduciary duty to protect their balance sheet. They must heed their own warnings and act now.