Keeping Risks in Check. Towards a Comprehensive Reflection of Climate Risks on Central Bank Balance Sheets

Central banks have a fiduciary duty to protect their balance sheet and thus to assess and manage the exposure of their holdings to financial risks. This applies irrespective of whether their core mandate focuses on price stability, exchange rate management, or economic growth and employment.

The thorough and cautious evaluation of all risks is necessary for the implementation of monetary policy, both through asset purchases and credit operations. Credibility of the central bank, protection of the public purse, and ultimately the value of a currency depend on keeping balance sheet risks under control.

Climate risks are a financial risk for all central bank balance sheets. They need to be considered for the management of foreign reserves, such as those held by the Monetary Authority of Singapore and the Swiss National Bank, as well as for asset purchases in the context of quantitative easing, such as those by the European Central Bank and the Bank of Japan.

As Jens Weidmann, former president of the Deutsche Bundesbank, stated in reference to financial concerns associated with climate change: “We owe it to European taxpayers to keep the financial risks that result from our monetary policy operations in check. […] That’s why central banks, too, should make sure that climate-related financial risks are given due consideration in their own risk management, especially in the securities portfolios held for monetary policy purposes.”

Against this background, several central banks have started to take climate risks into account in their monetary policy operations. So far, most of these risk management policies remain limited to certain parts of their portfolios, and focus primarily on corporate bonds. For example, the European Central Bank (ECB) and the Bank of England (BoE) have implemented detailed policies on how to manage the climate risk exposure of their corporate bond portfolios.

However, given the fact that climate risks are financial risks for all asset classes, a comprehensive assessment of climate risks across all central bank operations and invested asset classes is required. To fulfill their fiduciary duty, central banks must urgently expand the integration of climate risk considerations into risk management across all their holdings – including equities, covered bonds, asset-backed securities and government bonds.

Accounting for climate risks in central banks’ equity holdings in addition to their corporate bond portfolios is a critical first step in this direction.

To that end, the Monetary Authority of Singapore (MAS) has started “taking pre-emptive actions to mitigate the impact of climate risks on [its] equities investments from an accelerated low-carbon transition”. Its approach includes an overlay program covering its entire equities portfolio as well as allocations to dedicated climate change and broader sustainability strategies. It is also requiring its external managers to engage portfolio companies and vote on climate risks and is excluding companies that derive more than 10% of their revenues from thermal coal mining and oil sands.

In contrast, the Bank of Japan (BoJ) has not yet implemented policies to manage climate-related risks in its large equities portfolio. Given its significant exposure of 37 trillion JPY (274 billion USD) to the Japanese equities market moving in this direction is urgent and critical. The BoJ already has experience with integrating further considerations into its equity investments. In 2016, it allocated a share of its equity portfolio to index-based equity purchases of firms that are proactively investing in human and physical capital. Following a comparable approach to reduce climate risks in its equity holdings is easy to implement. The index providers used by the BoJ already offer multiple versions of Japanese equity indexes that account for climate risks. Aligning their equity holdings to track these indexes instead of the ones the BoJ tracks today is a straightforward step to take.

The Swiss National Bank (SNB) is a similar case. With 784 billion CHF (850 billion USD) in foreign exchange reserves, it holds one of the largest reserve portfolios globally. As Andréa Maechler, a member of the SNB Governing Board, and Thomas Moser, a member of its enlarged Governing Board, highlighted, “climate risks could impact the risk/return profile of [the SNB’s] assets and hence the strength of [its] balance sheet.” “Factoring climate risks into risk assessment is therefore an integral part of good portfolio management.” For its corporate bond investments, the SNB has reported following this credo. For its equity investments, however, it does not, choosing instead to track a strategic benchmark of global equity markets with an overweight in large and mid caps versus small caps. It excludes certain companies for ethical considerations, but has so far not taken a comprehensive approach to managing the climate risks in its equity holdings. As described for the BoJ above, it is an easy and urgent step to change that.

Reflecting climate risks in further asset classes is equally critical. As Isabel Schnabel, Executive Board member of the ECB, recently underscored, climate risks must be accounted for across all its private sector holdings, including covered bonds and asset-backed securities, as well as its public sector exposures. Climate risks to mortgages used as security for covered bonds are a case in point. Asset-backed securities based on car loans and related climate risks provide further illustration.

Similarly, the ECB must also reflect climate risks in its public sector holdings. Whilst sovereign bonds have long been under the climate risk management radar, there is an emerging body of research and industry initiatives to identify meaningful methods to assess the climate risks they are exposed to. The Swedish Riksbank has already applied climate risk analysis to its investments in subnational government bonds.

Central banks must account for climate risks to fulfil their fiduciary duty. Whilst some have introduced corporate bond climate risk management policies, only very few have started to reflect climate risks in other asset classes.

To address this shortfall, applying climate risk analytics to central bank equity portfolios is a critical first step. The analytics to do so are available. The inconsistency between applying these analytics to the bonds of corporate issuers, but not to their equities, is remarkable. Building on these analytics to assess other private sector assets, such as covered bonds and asset-backed securities, as well as public sector exposures is equally vital.

Central banks have been highlighting the financial risks from climate change for several years. The fact that they are still not accounting for these risks across all their operations is striking. This must change.