Banks, climate risk and financial stability

Publication Date13 May 2019
Date13 May 2019
AuthorMaria J. Nieto
SubjectAccounting & Finance,Financial risk/company failure,Financial compliance/regulation
Banks, climate risk and
f‌inancial stability
Maria J. Nieto
Bank of Spain, Madrid, Spain
Purpose This paper aims to quantify the (syndicated) loan exposure to elevated environmental risk
sectors of the banking systemin the USA, EU, China, Japan and Switzerland at US$1.6tn and to highlight its
importance,which ranges from 3.8 (USA) to 0.5 per cent (China) in terms of total national banking assets. The
paper highlights the relevance of exploring prudential policy responses, including a harmonized taxonomy,
statisticaland reporting framework that could contributeto internalizing the negative externalitiesassociated
with climate risks by both banks and their supervisors. Among the prudential supervisory tools, credit
registers facilitate the assessment of environmental risk drivers in carbon stress tests.This paper also
presentsa frameworkof analysis for the regulatory treatment of climate-relatedrisks.
Design/methodology/approach Similarly to Weyzig et al. (2014),this paper uses f‌inancial databases
on the banksrole asbook runners for syndicated loans; that is, as thelead arrangers who also provide a large
share of the actual lending. Loans are outstanding on December 31, 2014, and the paper assumes linear
amortizationof loans issued before that date and withmaturity after that date. This study includesthe largest
banks from the above-mentioned countries with f‌inancial information available in SNL Financial and EU
banks with f‌inancial information available in the ECB database on December 31, 2014. By assessing the
relative share of the ten largest (or total reporting if less) banksexposure to each high environmental risk
sector in relation to their total assets, these f‌indings can be extrapolated across sectors in the respective
Findings This paper quantif‌ies the loan exposureto elevated environmental risk sectors of the banking
system in the USA, EU, China, Japan and Switzerland in US$1.6tn, broadly in line with the f‌indings of
Battiston et al. (2017) and Weyzig et al. (2014). This paper also explores prudential policy approaches and
tools. In addition to the lack of taxonomyof brownvs green,the paper identif‌ies the limitations to assess
the risks involved in the transitionto a low-carbon economy: supervisoryreports that do not make full use of
the existing internationalstatistical framework (e.g. EU COREP and FINREP); lack of harmonizedreporting
requirements of environmental risks; lack of credit registers as tools to perform carbon stress-testing; and
supervisorsgovernanceframework that do not internalize environmental risks (e.g. proposedrevision of the
Basel Core Principles of Banking Supervision). As per the stress-testing, the paper presents two examples.
The paper presents a frameworkof analysis for the regulatory treatmentof climate-related risks. The author
identif‌ies two critical elements of such framework if prudential regulation of environmental risks is to be
considered: the considerationor not of climate risk as credit risk and the impact of environmental risks over
probabilitiesof default over the entire business cycle.
Research limitations/implications No internationally accepted off‌icialtaxonomy of high
environmentalrisk sectors exists. This paper uses Moodys (2015a) classif‌icationof sectors according to their
environmentalrisk exposure. This papers exposures do not ref‌lect the real risk exposure of these institutions
and the banking industry as a whole because, as explained in Page 6, these values are without regard to
bilateral loans and guarantees and securitizations of loans; in the case of loans to power generation
The views expressed here are those of the author and do not necessarily represent those of Bank of
Spain or the euro system. The author thanks Kern Alexander and Willem Pieter De Groen for their
comments and support to an initial draft; Marco Bardoscia and all the participants of the IWFSAS
Conference in Montréal (August 24-25, 2017), Seminar at the International Monetary Fund (February
27, 2018) and Seminar at Bank of Spain (April 27, 2018); and Martin
Cihák, Carlos Perez and Hiroko
Oura for their suggestions and Anna Gorris for her valuable contribution as research assistants. Any
errors are the authors.
Climate risk
Received12 March 2018
Revised18 July 2018
Accepted27 July 2018
Journalof Financial Regulation
Vol.27 No. 2, 2019
pp. 243-262
© Emerald Publishing Limited
DOI 10.1108/JFRC-03-2018-0043
The current issue and full text archive of this journal is available on Emerald Insight at:
companies, renewable sources are not excludingand, similarly, for the production of electric vehicles, loans
are not excluded. Furthermore, this paper does not assess banksexposures to sovereigns subject to high
environmental risks and bonds and equity issued by corporations operating in high environmental risk
Practical implications Contributionto the present policy debate on how to regulate banksexposure to
high environmentalrisk and how to manage the transitionto a low-carbon economy.
Social implications This paper can increase awarenessof the banking sector transition risks to a low-
carbon economy.
Originality/value This paper quantif‌iesbanks direct exposures to high environmentalrisk sectors using
an ample def‌initionof sectors exposed to environmental risk. The author suggestspolicy actions to assess the
environmental risks. The author def‌ines a regulatory framework for banks to internalize the negative
externalitiesof environmental risks.
Keywords Environment, Governance, Regulation, Banking
Paper type Conceptual paper
1. Introduction
The need for decisive policyaction on climate change is broadly acknowledged. Since 1979,
international agreements have intended to increase awareness of climate change risks and
the associated need to reduce greenhousegas emissions. Most recently, the Paris Agreement
was adopted at the Paris Climate Change Conference (December 2015) to strengthen the
global response to thethreat of climate change[1].
Financial policy and regulation are increasingly recognized as important
dimensions of the transition toward a low-carbon economy that is consistent with the
full implementation of the Paris Agreement[2]. On the one hand, the speed and the
smoothness of the transition to a green economy and the adjustment costs could affect
systemic f‌inancial risks. On the other hand, there is a growing recognition now that the
inculcation of green guidelines and standards into bank lending, trading and
investment practices is critical for achieving the core mandates of International
Financial Organizations, such as the International Monetary Fund (IMF, 2015a)andthe
World Bank. Economic growth and f‌inancial development should aim to be
economically, socially and environmentally sustainable (IMF, 2015b).
The contributionof this paper to the literature is threefold:
(1) It quanti f‌ies the (syndicated) loan exposure to elevated environmental risk
sectors of the banking system in the USA, EU, China, Japan and Switzerland.
To the best of the authors knowledge, it is the f‌irst international comparison of
banksloan exposures to high environmental risks. In contrast to Battiston
et al. (2017), who use a network analysis of the exposures of all f‌inancial actors
to all climate-relevant sectors of the economy and the exposures among
f‌inancial actors themselves across several types of f‌inancial instruments, this
paper focuses on banksdirect exposures using Weyzig et al. (2014). Differences
between Battiston et al. (2017),Weyzig et al. (2014) and this paper are described
in Table I.
(2) It explores prudential policy approaches and tools: In addition to the lack of taxonomy
of brownvs green, the paper identif‌ies the limitations to assess the risks involved
in the transition to a low-carbon economy: supervisory reports that do not make full
use of the existing international statistical framework (e.g. EU COREP and FINREP);
lack of harmonized reporting requirements of environmental risks; lack of statistical
data bases and credit registers as tools to perform carbon stress-testing; and

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