1. A financial system allows for the exchange of money and financial instruments through financial markets and institutions like banks.
2. Climate change can impact the financial system through physical risks from weather events damaging assets, transition risks from policy changes decreasing asset values, and liability risks of compensation claims.
3. Central banks are working to address these climate-related financial risks through organizations like the Network for Greening the Financial System, which researches potential policy solutions among its nearly 100 member central banks and organizations.
Original Description:
Original Title
Neoma How is climate change impacting the financial system oct 2022
1. A financial system allows for the exchange of money and financial instruments through financial markets and institutions like banks.
2. Climate change can impact the financial system through physical risks from weather events damaging assets, transition risks from policy changes decreasing asset values, and liability risks of compensation claims.
3. Central banks are working to address these climate-related financial risks through organizations like the Network for Greening the Financial System, which researches potential policy solutions among its nearly 100 member central banks and organizations.
1. A financial system allows for the exchange of money and financial instruments through financial markets and institutions like banks.
2. Climate change can impact the financial system through physical risks from weather events damaging assets, transition risks from policy changes decreasing asset values, and liability risks of compensation claims.
3. Central banks are working to address these climate-related financial risks through organizations like the Network for Greening the Financial System, which researches potential policy solutions among its nearly 100 member central banks and organizations.
financial system? Neoma Business School Jérôme COURCIER Paris October 12, 2022 Money & the financial system
A. What is a financial system
B. What is a financial market? C. What is a financial institution? D. What is a central bank?
Climate change impact
1. How is climate change impacting banks
2. Should central banks address climate change? 3. How can climate change impact the financial system ? 3. What can central banks do about climate-related financial risks? 4. How do central banks measure up? 5. What can market watchdogs do?
Conclusion: why did it take so long for central banks to react?
What is a financial system?
• A financial system is a set of institutions and markets
that permit the exchange of money and other financial instruments. • In most financial systems, participants can use two separate channels to meet each other. - Savers can lend directly to borrowers by investing in financial securities through a financial market that will brings them face to face to buy and sell bonds, stocks, and other financial instruments. - Savers can deposit their funds into a bank / financial institution that in turn, lends to the borrowers. It provides three benefits to the depositor: 1. banks collect information about borrowers and lends to them with a low chance of defaulting on their loans 2. their lending activity is diversified and reduces investment risk 3. they are supposed to be liquid, and savers can easily convert their deposits into cash. What is a financial system?
• In the United States, companies are mainly (75%)
financed on the financial markets. In Europe, they mostly (80%) use bank credit. Why? • Because on September 2, 1974, President Ford promulgated the Employee Retirement Income Security Act (ERISA) : 1. company pension funds are autonomous financial bodies 2. they have to diversify their investments and keep their promise of annuity over the long term 3. the search for short-term profit is a "fiduciary duty", an obligation of loyalty. • Since then, they place the contributions collected in the capital of listed companies. • As a result, from the mid-1970s onwards, a huge portion of American household savings are placed in the stock market. What is a financial market? • Financial markets refer to any marketplace where the trading of securities occurs, including the stock market, bond market, forex market, and derivatives market, among others. They can be organized physically in a location like the NYSE or through computer networks like NASDAQ. • In the USA, to tap the financial markets, one has to receive an agreement from the Securities and Exchange Commission (SEC) which mainly requires borrowers to disclose financial information based on acceptable accounting standards. • Together with all the other market authorities around the world (FSA in the United Kingdom, the AMF in France, BaFin in Germany ...) it is part of the International Organization of Securities Commissions (IOSCO) which promotes the emergence of standards in trade on international markets, cooperation between market authorities in their monitoring activities and joint reflection on the operation and regulation of the markets. • The objective is to ensure financial stability (i.e. prevent or withstand unintended fluctuations and shocks) and efficiency (to provide low-cost financing) which are paramount to economic growth and development, and investors’ confidence. What is a financial institution? • A financial institution is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments, and currency exchange. • Banks do not act merely as intermediaries, lending out deposits that savers place with them. In the modern economy, banks create the money by deciding who to lend to and how much to lend, depending on the risk profiles and the profitable lending opportunities available to them. • As long as loans make deposits, it is the lending decisions made by banks that determine how many bank deposits are created by the banking system. This amount influences the amount of central bank money that banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then supplied by the central bank, in exchange for other assets on their balance sheets. • Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw base money in large amounts. What is a financial institution? • Banks are limited in the total amount they can lend by 1. credit risk (applicants potential insolvency) as they want to remain profitable in a competitive banking system 2. profitability of making a loan which depends on the cost of funds that banks face, which is closely related to the interest rate paid on base money reserves 3. capital adequacy ratios (prudential regulation) 4. broad money to base money ratios 5. required-reserves ratio which obliges banks to keep percentage of their deposits at an account at the central bank. • To become a financial institution, one has to receive a license / charter from a government body and accept to be regulated by government agencies. In the USA, it is the Office of the Comptroller of the Currency (OCC), within the U.S. Treasury Department. The OCC is part of the Basel accords which are an international effort to determine the amount of capital a bank should hold to honor its commitments to its customers and to maintain its financial viability when it suffers unexpected losses. Close-up: the Basle accords • Basle I, set in 1988, required banks to hold 8% of their risk-weighted assets as equity / cash reserves to cover credit risk. Assets were classified into four categories based on risk weights: 0% for risk-free assets (cash, treasury bonds); 20% for loans to other banks or securities with the highest credit rating, 50% for residential mortgages, and 100% for corporate debt. • Basel II, introduced in 2004, added market risk and operational risk (failure of internal control attributable to personnel or IT systems) to credit risk • Basel III, created in 2010, after the Global Financial Crisis, added to Basel I minimum capital requirements (called Pillar 1), supervisory mechanisms (Pillar 2), and market discipline (Pillar 3). -As banks are allowed to use their own estimated risk parameters, Pillar 2 empowers regulators to scrutinize bank’s risk-weight calculations (SREP), and pass judgement on the suitability of the resulting risk-weighted assets (RWA) amounts. In the European Union and UK, if regulators believe a bank’s own RWA assessments are deficient, they can impose capital add- ons (ICAAP) at their discretion. - As regulators think that markets are efficient, Pillar 3 forces banks to publish periodic risk disclosures in order to give investors the relevant information they need to make informed trading decisions. What is a central bank? • A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a state and oversees its financial institutions. In normal times, it controls money by: 1. moving the interest rate paid on central bank reserves held by commercial banks which influences a range of interest rates in the economy, 2. changing the required-reserves ratio of base money 3. buying/selling “Govies” (open-market operations). • But once short-term interest rates reach the effective lower bound, it is not possible for the central bank to provide further stimulus to the economy by lowering the rate at which reserves are remunerated. One possible way of providing further monetary stimulus to the economy is through an asset purchase program of long-term securities (Quantitative Easing). What is a central bank? How can climate change impact the financial system? • In 2015, at the Lloyds, Bank of England governor Mark Carney raised an alarm about the “tragedy” of climate change and warned specifically about “re-pricing” events. That includes: 1. physical risk: damage that destroys the value of assets (such as waterfront properties), or sharply raises insurance prices. 2. transition risk: sudden slump in the value of certain assets because of drastic government action to combat climate change, like the introduction of a steep carbon tax or regulations that keep fossil fuels in the ground. 3. liability risk: people seeking compensation for losses related to the first two (as shown by California utility giant PG&E Corp.’s wildfire-driven bankruptcy) . • Therefore, in 2017, Carney and several peers created the Network for Greening the Financial System (NGFS), a group that’s grown to nearly 100 central banks and related organizations that swap research and potential policy solutions. How can climate change impact the financial system? Direct physical risk • Physical risks arise from the increasing severity and frequency of extreme climate and weather-related events, and chronic shifts in weather patterns (temperature, sea levels …). • Even though it is not a capital-intensive industry, as the banking sector is operating in some vulnerable parts of the world, it faces some direct impacts on their: - facilities (office towers and data centers) - resources (data centers consume a lot of electricity, and cooling servers require large amounts of water) - people (loss of employees and customers) - markets (changing demand for goods and services) - finance (funding and insurance costs) - reputation • Enterprise risk management, business continuity planning, scenario planning, and other approaches to assessing and managing risks, can help banks manage those risks. Physical risk analysis of a retail banking real estate portfolio
Location Score Energy Heat Heavy Hydric Sea
Indirect physical risk wave rains stress level Rochefort 64 33 44 97 66 82 • Banks can be affected by impacts beyond their boundaries as they rely on local communities for employees, suppliers, and customers, La Roche s/Yon 64 75 63 52 66 - and also depend on local resources, services, and infrastructure. Marcy- 62 73 70 81 25 - l’Etoile • Corporate customers: extreme climate and weather-related Caen 61 64 73 83 25 - events can result in a loss. In 2003, the extreme drought and heat St 61 67 71 79 25 - wave that hit Europe costed EUR 300 million to EDF. In 2011, he Maurice severe flooding that occurred in Thailand and disrupted Toyota’s Maisons- Lafitte 59 44 73 96 25 - supply chains cut its profits by $2.5 billion. In 2018, the low water Ecully 54 66 70 54 25 - level of the Rhine impacted BASF earnings by EUR 200 million. Nantes 51 31 57 92 25 - • Retail customers: the Bank of England has analyzed that 8.8% of Chatou 50 33 44 97 25 - the country's current mortgage exposure was in an area at risk of flooding. Potentially hurting both the repayment motivation, the financial capacities and the collateral power of the borrowers. • For a long time, the physical climate risk was underestimated by banks, because it was supposedly covered by the insurance industry, but in 2015, AXA Chairman and CEO Henri de Castries said: “a 2°C world might be insurable, a 4°C world certainly would not be”. Transition risk • Transition risks arise from the significant structural changes required for economies to adjust towards a low-carbon economy (disruptive innovations, policy changes including carbon pricing policies, shifts in consumer preferences). • These transition risks can lead to assets becoming “stranded”, i.e., losing value as a result of unanticipated changes in expected cash flows. Uncertainty surrounding climate change policies and their pace is one driver of transition risk. • As U.S. accounting rules require companies to write down an asset when its projected cash flows fall below its current book value, oil-and-gas companies in North America and Europe wrote down roughly $145 billion combined in 2020. • Banks have therefore started to calculate a Transition Risk Index for each "corporate" client by combining the carbon intensity of financing (from GHG emissions), the effort to reduce State emissions (on the basis of their Intended National Determined Contributions) and the relative maturity level of the client (Net-Zero strategy). Transition risk • A KPMG study showed, in 2012, that the environmental externalities of the major industrial sectors represented 41% of their net income before tax,… without appearing in the financial statements. • Today, companies only publish EBESDAs, that is, Earnings Before Environmental and Social Depletion and Amortization. In the same way as today the RORAC (Return On Risk-Adjusted Capital) measures profitability by taking into account the financial risk of the borrower, tomorrow the CAROC (Carbon cost-Adjusted Return On Capital) should measure the climate risk of any borrower, and thus link financial and extra-financial analysis. • A recent study by Kempen Capital Management shows that a global carbon price shock of $ 150 on polluting companies could cause global equity valuations to drop by 8% in the case of Scopes 1 and 2 emissions, and 40% in the case of Scopes 1, 2 and 3 issues. Transition risk Liability risk • Climate change litigation continues to grow in importance. Globally, the cumulative number of climate change-related cases has more than doubled since 2015. Just over 800 cases were filed between 1986 and 2014, while over 1,000 cases have been brought in the last six years. • Cases are targeting a wider variety of private sector and financial actors and there is more diversity in the arguments being used, incorporating, for example, themes of greenwashing and fiduciary duty. • The number of cases challenging government inaction or lack of ambition in climate goals and commitments continues to grow, with 37 ‘systemic mitigation’ cases identified around the world. • Three areas to watch in the future are value chain litigation, cases of government support to the fossil fuel industry (e.g. through subsidies or tax relief), and cases focused on the distribution of the burdens associated with action, which may be classed as ‘just transition’ cases. Should central banks address climate-related financial risks? • A growing body of research suggests that climate change poses the greatest long-run threat to the global economy, including inflation and financial stability, the traditional purview of central banks. • The world’s economies are likely to be affected in multiple ways by climate change. A company can be affected by extreme heat in different ways: on its buildings, its processes, its electronic equipment, its employees, its supplies, its stocks or even its logistics. All of the impacts ultimately lead to a slowdown or temporary / permanent stoppage in bad cases of activities, additional operating costs, and additional investments. • In a double materiality approach, or doom loop, one also realizes that the financial system makes global warming possible as the enabler of fossil fuel exploration and production (inside-out extra-financial impact), and, in return, the environment strikes back and take the financial system down (outside-in financial impact). Should central banks address climate-related financial risks? • On November 2020 Bundesbank chief, Jens Weidmann, said that central banks can explore requiring better risk disclosures, but cannot make up for a lack of political will, as “when it comes to saving the planet, central banks do not have a magic wand”. Similarly, many central bankers think that they do not have the power to change society’s economic behavior. According to them, one should change first their clients’ behavior (in this instance, fossil fuel companies), before changing theirs, as “they finance the world as it is”.
• In February 2021, Frank Elderson, a member of the Executive Board of
the ECB, stated that the fact that the European Central Bank has to care about climate change squares with its mandate. Why? Because climate change mitigation is a precondition required for the pursuit of ECB’s primary objective which is to maintain price stability. Furthermore, the Treaties give the ECB the obligation to support the general economic policies in the Union, and the latter aim to contribute to the sustainable development of Europe based on a high level of protection and improvement of the quality of the environment. Should central banks address climate-related financial risks? • The response to “green is not less risky than brown”, came, in September 2020, from Energy Efficient Mortgages (EEM) Initiative, a pan-European private bank financing mechanism that aims to stimulate and finance investment in energy efficient buildings and energy saving renovations. After analyzing 72,980 individual mortgage loans in Italy, their econometric evaluations highlighted a negative correlation between energy efficiency and the owners’ probability of default, confirming that energy efficiency investments tend to improve owners’/borrowers’ solvency. • The response to “banks finance the world as it is” argument came from Finance Watch who reminded that finance is that very special human activity that makes other human activities possible, as it has been delegated the function of extending credit, i.e., the power of making specific economic activities possible or not. Therefore, when financial institutions bring capital to fossil fuel companies, they enable climate change and feed a situation that will backfire and destroy them. What can central banks and financial regulators do? • In their bank supervision mission, central banks can have an impact on climate related financial risks by: 1. increasing their research in order to inform policy makers; 2. forcing banks to calculate and disclose their climate-related risks 3. including climate-repricing scenarios in the stress tests they require to make sure banks are prepared for losses. 4. tweak bank capital rules to provide preferential treatment for exposure to green assets.
• When it comes to monetary policy, options include:
1. variability of interest rates 2. changes to collateral rules 3. shifting asset-purchase programs to limit exposure to so-called brown industries with high greenhouse gas emissions 4. green quantitative easing, where central banks would deliberately funnel bond-buying toward green projects and companies and thus lower borrowing costs for such industries. How do central banks measure up on monetary tools? • The Bank of Japan offers cheaper funding to financial institutions lending to climate-friendly businesses. • The People’s Bank of China provides direct investment in sustainable projects and provide cheaper funding to institutions supporting emission-cutting projects. • The Bank of England introduced ESG criteria in open-market operations. • Sweden’s Riksbank has cleansed its reserves of assets tied to pollution and started mapping the carbon footprint of its corporate bond purchase program. • Banque Du Liban differentiates reserve requirement ratios according to the amount of lending going to renewables and energy efficiency. • Banque de France includes climate risks in the financial value assessment of the collateral that it asks when lending money to banks. How do central banks measure up on monetary tools? On July 4th, 2022, the ECB announced the greening of its corporate debt portfolio and collateral framework How do central banks measure up on supervision ? • Regulators favor the Pillar 3 approach, and encourage banks to examine and disclose their exposures, via scenario analysis and stress testing. The Bank of England and Banque de France both started a major stress test of their country’s biggest banks and insurers to judge how resilient they are to climate change. • As it takes the form of a private negotiation with each institution using an internal model for calculating its capital requirements, others are in favor of having climate-related and environmental reflected in Pillar 2 capital add-ons. • The European Banking Authority (EBA), wants to include those risks in the supervisory review and evaluation process (SREP), and proposed to mandate European banks to publish a green asset ratio (GAR), which could become a Green Asset Floor (GAF) in order to increase the bank foundations in the face of climate risk. In this Pillar 2 approach, one could also envisage quantitative restrictions on the “dirtiest” forms of lending, like a “brown” asset ratio (BAF), or a complete prohibition, to send a strong market signal. • Only Hungary’s MNB has yet changed its Pillar 1 requirements and introduced a green supporting factor for energy efficient housing loans in order to reduce interest rates on new green housing builds and retrofits. What can market watchdogs do? • In March 2020, the “Autorité des marchés financiers” (AMF) published its doctrine on ESG (environmental, social and governance) communication for fund managers, in order to "ensure better legibility of the offer for the general public ". • In March 2021, the Securities and Exchange Commission (SEC) announced that US companies’ climate disclosures will be policed by a specialist team, in line with the watchdog’s renewed focus on ESG and sustainability issues. • In August 2021, BaFin and SEC announced they were investigating allegations raised by DWS’s former sustainability chief, Desiree Fixler, that the firm overstated the amount of assets invested using its ESG screening process. DWS stated in its 2020 annual report, that more than half of its $900 billion assets were subject to ‘ESG integration’, where companies are vetted using ESG criteria. Fixler claims that in reality only a fraction of assets went through this process, as the ESG integration process did not screen out companies involved in climate-harming activities like coal and fracking. Fixler was fired by DWS in March before the annual report’s release. DWS’ stock price slumped. Conclusion: why did it take so long for central banks to react? • As central bankers aren’t elected, and supposed to be independent, they typically avoid delving into political debates. • Because the time horizon for monetary policy is about 2 to 3 years, and climate change timelines are much longer, central banks think they are ill-equipped to have a meaningful impact. • The current approach to making the financial system more sustainable is still dominated by the efficient market hypothesis, and therefore central bank policy intervention is essentially devoted to stimulating that market efficiency. • The dominant ethical framework is minimalist i.e., indifferent to the various conceptions of the good (principle of neutrality), gives the same value to the interests of each (principle of equal consideration), and only intervenes in the event of gross wrongs caused to others (principle of limited intervention). On this basis, some say that addressing the causes of climate change is a decision for governments and parliaments (principle of neutrality) and others that central banks shouldn’t promote certain types of assets rather than others (principle of equal consideration) and capital requirements should be set based on the inherent risk profile of each asset class, which is yet unclear (principle of limited intervention). Case study: what should central banks do to fight climate change? • You have joined Reclaim Finance with a 6-month fixed-term contract based in Paris, as they were looking for someone dynamic and passionate who wants to help accelerate the decarbonization of finance. • Your main responsibilities are to: - analyze the policies of central banks - produce some advocacy and campaign materials based on our analyses • You have strong analytical and synthesis skills, a keen sense of strategy and priorities. • You have excellent interpersonal skills and are able to build strong relationships with a wide range of different stakeholders • You have strong oral and written communication skills and are persuasive. • Analyse what central banks should do to fight climate change.