Policy brief
Climate change is now a recognised source of financial risk for banks. This report quantifies global banks’ fossil fuel exposures and shows how early macroprudential action can make banks more resilient and reduce the build-up of climate risks in the financial system – without hurting lending capacity.
A dangerous, trillion-dollar feedback loop
As climate chaos relentlessly unfolds, new systemic risks are appearing and the banking sector is particularly exposed. Through more than USD 1.6 trillion in lending to the fossil fuel industry (see report p.9), the world’s 60 largest banks nurture a double feedback loop.
1) On the bumpy road to net-zero, these fossil fuel assets will inevitably suffer sharp devaluations, exposing banks to significant transition risks and
2) These substantial investments drive climate chaos which contributes to the system-wide buildup of physical climate risks, to which banks are also exposed.
Current prudential approaches fall short
Conscious of the threat to financial stability, supervisors are requiring banks to quantify this risk for direct input into the existing risk management framework. The problem: quantitative tools like risk management models, stress tests and disclosure requirements are poorly suited to the non-linear, forward-looking nature of climate risk. They rely heavily on past data or on climate scenarios that systematically underestimate the scale and complexity of future climate impacts, giving a false sense of security to financial markets. So far, macroprudential threats caused by the buildup of climate risk remain largely unaddressed by regulators, leaving the financial system increasingly vulnerable.
Costs and benefits of a climate systemic risk buffer
Finance Watch calls for the creation of a climate systemic risk buffer, and shows how this could be calibrated through a loan-to-value approachOne of the most fundamental rule of financial risk management is to ensure the reasonable relationship between the amount of financing provided, the loan, and the economic value of the assets financed, the value. Historically, macroprudential authorities over the world have imposed loan to value limits on mortgage loans, typically between 80% and 100% of the house value, with variations depending on the quality of borrowers, market conditions etc.. It would reduce taxpayer exposure by curbing the buildup of systemic risk early and shielding banks’ transition losses. It would also remove a market distortionFinance Watch calculates that the current underpricing of fossil fuel risk creates an implicit subsidy of 0.76% on fossil fuel loans, worth an estimated USD 8.7 billion per year. A climate systemic risk buffer would contribute to removing this market distortion and improving financing conditions for sustainable energy markets. on energy markets. Importantly, the buffer would have no impact on lending capacity at European banks (see report p.24), and a positive one on their competitiveness. Finance Watch calls on financial authorities to resolutely undertake regulatory action under their mandate from Article 501c of the Capital Requirements Regulation.
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