Warming planet revolutionises how banks define risk

New York

EUROPEAN banks need to prepare for new capital requirements that will reflect how exposed their loan books are to climate change, said Fitch Ratings.

"That is the logical next step," said Janine Dow, a senior director for sustainable finance at the ratings company. "Because once you size a problem, then you identify the risk. And as a regulator, you can't just leave an emerging risk exposed."

Such a requirement would mark a significant expansion of new rules that the financial industry in Europe is now facing amid a race against time to prevent an environmental catastrophe. The goal is to force banks to channel money away from those corners of the economy that pollute, and towards businesses that have committed to lower carbon emissions.

For now, banks remain a long way away from that goal. Since the Paris Climate Agreement was struck in 2015, lenders globally have poured more than US$3.6 trillion into fossil fuel financing, data compiled by Bloomberg showed. Only this year has green bond and loan financing taken the lead.

According to Fitch, the financial industry is well aware that bank capital requirements will soon reflect climate risk, even though regulators themselves have not yet spelled out their intentions.

"Regulators haven't been more explicit yet because they don't have the data to justify a clear approach," said Monsur Hussain, a senior director for financial institutions at Fitch.

But "if you read between the lines" of the European Central Bank's (ECB) November guidelines on climate-related and environmental risks for banks, "that is the direction of travel", he added.

In the guidelines, the ECB instructs banks to consider their sensitivity to climate risk when weighing how much capital they need beyond minimum requirements; with this so-called Pillar 2 exercise, mandatory requirements have "already made landfall", Mr Hussain said.

"The only question is, how long will it take to make landfall on Pillar 1," which represent banks' minimum requirements and is "the key metric by which regulators decide whether a bank lives or dies," he added. "That's really where I think the rubber will hit the road."

The key hurdle now is ensuring that banks get the data they need from companies to enable them to assess their climate risks. And that is where even regulators are sounding the alarm.

"The issue which concerns me most right now is whether the non-financial sector is capable of delivering the information to the financial sector - which the financial sector demands, and which it will have to have given the whole disclosure and taxonomy apparatus which is being implemented," said Jesper Berg, the director general of the Danish Financial Supervisory Authority.

As the top financial supervisor in a country that is ranked the world's greenest, Mr Berg noted that even in Denmark corporations are facing a huge task. He also said that requirements for corporations to provide data have lagged behind disclosure demands being made on banks.

"As a public authority, we need to flag this issue and the risks so that companies know that they need to do something, possibly at an earlier stage than they expected to do it," Mr Berg added. "This is not a small challenge for the private, non-financial sector."

Ms Dow said regulators and lawmakers have so far only indirectly addressed the issue of whether banks should have buffers to absorb potential losses from climate catastrophes.

"If we think of classifications and even stress testing for climate change, none of the regulators have said that the output is going to be directly helping inform capital requirements," she said. Still, "we think that increasingly regulators are looking at capital requirements on this, taking this holistic approach". BLOOMBERG