5. Sustainability-Related Risks and Financial Stability: A Systemic View and Preliminary Conclusions

In this respect, the Basel Committee on Banking Supervision (BCBS) published in October 2012 a principles-based framework for dealing with domestic systemically important banks (BCBS 2012). The European Union implemented this framework in the Capital Requirements Directive (CRD IV) and the European Banking Authority adopted guidelines that recommend to the national macroprudential authorities the approach to follow for the identification of systemically important banks at the domestic level. Hence, national authorities designate systemically important banks and set capital buffers for them.

See for example Allen and Wood (2006).

An example of the structured mix of the regulation and organisational structure in place to ensure financial stability is the one adopted in the European Union (EU). In the EU, financial stability is first nested in the framework defined by the combination of the so-called Banking Union and Capital Markets Union. The Banking Union is mainly built around the Capital Requirements Directive and Capital Requirements Regulation (CRD IV-CRR package, derived by the Basel Accords), the Bank Recovery and Resolution Directive (BRRD) and the Deposit Guarantee Schemes Directive (DGSD). The overall aim of these pieces of legislation is to enforce financial stability through a mix of measures designed to both reduce and share banking sector risks. In this respect, the Banking Union eventually results to be based on three pillars: a single supervisory mechanism (SSM), a single resolution mechanism (SRM) with a related single resolution fund, and a European deposit insurance scheme (EDIS). However, the EU macro-prudential framework is to a significant extent implemented in a decentralised way. Authorities in the Member States identify risks and may implement macro-prudential measures within the remit of their jurisdiction. Such a decentralised set-up is mainly due to the fact that systemic risks are often local or national in scope and interrelate with specific national situations (see for example EC 2019a). To balance this decentralised implementation, the EU macro-prudential framework also comprises mechanisms to avoid excessive heterogeneity. To this extent, the European system of financial supervision (ESFS) was introduced in 2010. It comprises the European Systemic Risk Board (ESRB), which ensures that the objectives of financial integration at EU level and financial stability at the Member State level can be jointly pursued, and the three European supervisory authorities (ESAs), namely: the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA). On the other hand, financial stability is also fostered through the implementation of the Capital Markets Union, the blueprint headed by the European Commission to channel financial resources to all types of companies and infrastructure projects that need it to expand and create jobs. A first specific action plan to build the Capital Market Union has been published in 2015 (see EC 2015).

Central banks act to pursue specific objectives as defined by their statutory documents. For example, the main objective of the European Central Banks (ECB) is to maintain price stability, defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area close but below 2%. In addition, without prejudice to the objective of price stability, the ECB may support the general economic policies in the Union. These may include, inter alia, full employment and balanced economic growth.

For a wider analysis of the relation between sustainability-related risks and financial risks, see Chapter 1.

See IPCC (2018) or BIS (2020).

For further details, see Chapter 4.

See, as concerns global warming and climate change, IPCC (2018).

For a wider dissertation on the Paris Agreement and the Sustainable Development Goals, see Chapter 1 or Berrou et al. (2019b).

In particular for the Paris Agreement, the political commitment of the countries responsible for the largest part of the greenhouse gas emission is essential. In this respect, China counts for about 26% of the GHG emissions, the U.S. for 15%, the EU for 10%, India for 6%, Russia for 5%, Japan for 3%, Brazil for 2%. Source: World Research Institute. Data referred to 2014.

At European Union’s level, it should at least be listed the issuance of the European strategic long-term vision for a prosperous, modern, competitive and climate-neutral economy (EC 2018a) and the European Green Deal (EC 2019b).

In June 2017, United States President Donald Trump announced his intention to withdraw his country from the Paris Agreement. Under the agreement itself, the earliest effective date of withdrawal for the United States is November 2020.

For more details on possible definitions of sustainable finance and green finance, see UNEP (2016) or Berrou et al. (2019a).

See also Chapter 1.

As an example, investments of around EUR520–575 billion annually have been estimated to be necessary in the EU in order to achieve a net-zero greenhouse gas economy in the 2050 horizon (EC 2018a). In 2018, annual emissions of labelled green bonds (the major security in the green finance market segment) in the EU can be estimated in less than EUR50 billion (authors’ elaboration on data CBI).

Namely, to mainstream sustainable finance it would be needed that environmental and other sustainability-related risks are properly included in the investors’ decision-making processes, market demand is effectively channelled towards sustainable investments, additionality is adequately encouraged by policymakers when needed and the banking sector is fully engaged in the transition. For a more detail dissertation, see also Migliorelli and Dessertine (2019).

Estimates of losses are large and range from USD1 trillion to USD4 trillion when considering the energy sector alone (IAE and IRENA 2017).

See also Chapter 4.

The capital requirements set out in the Pillar 1 of the Basel III framework do not consider sustainability-related risks directly (capital is explicitly required only for credit and operational risk s related to borrowers that violate environmental regulations), so it can be argued that the Basel III framework is not adapted as such to promote a progressive integration of sustainability-related risks (Cambridge and UNEPFI 2014). Despite the fact it seems attractive to foster green lending by regulatory-based incentives linked to Pillar 1 (e.g. by lowering risk weights or by using other types of “green supporting factors”), the prudential regime should remain fully focused on risk management and any innovation carefully assessed. Weak material incentives (e.g. slightly lowered risk weights for sustainable assets) would probably not change the banks’ investment behaviour, whereas greater incentives may have the undesired effect to incentivise regulatory arbitrage towards exposures that absorb less regulatory capital while still bearing financial risk and existing regulatory uncertainties (e.g. related to the definition of sustainable, green or brown assets).

Launched at the One Planet Summit in Paris in December 2017 under the initiative of the Banque de France, the NGFS is composed by more than 30 central banks, supervisory bodies and international organisations (including Banco de España, Bank of England, Bank of Finland, Banque Centrale du Luxembourg, Deutsche Bundesbank, European Banking Authority, European Central Bank, Japan FSA, National Bank of Belgium, Oesterreichische National Bank, the People’s Bank of China, the Reserve Bank of Australia, Reserve Bank of New Zealand). It aims on a voluntary basis to exchange experiences and best practices, to contribute to the development of environment and climate risk management in the financial sector, and to mobilise mainstream finance to support the transition towards a sustainable economy. In 2019, the NGFS issued the first comprehensive report on climate change as source of financial risk (NGFS 2019).

The SASB (https://​www.​sasb.​org/​) is a non-profit organisation that sets financial reporting standards on the issue of sustainability. In this respect SASB standards have as objective to enable businesses to identify, manage and communicate financially material sustainability information to their investors.

The TCFD (https://​www.​fsb-tcfd.​org/​) aims at developing voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers and other stakeholders. The TCFD in particular considers the physical, liability and transition risks associated with climate change and what constitutes effective financial disclosures across industries.

In April 2020 Basel Committee published the main results of a survey (BCBS 2020) on the initiatives on climate-related financial risks conduct on 27 Basel Committee members, including the European Central Bank (ECB) and the European Banking Authority (EBA). A large majority of these supervisors detected that they do not have an explicit mandate with regards to climate-related financial risks, but indicated that such risks could potentially impact the safety and soundness of individual financial institutions and could pose potential financial stability concerns for the financial system. Then, these institutions believe they can act within their existing mandate to mitigate climate-related financial risks. Even if the climate-related financial risks are not specifically designated in their regulatory and supervisory framework, most of these supervisory authorities consider these risks to fall implicitly within their existing framework, since the existing prudential framework requests banks to manage all risks of relevance, including climate-related financial risks. However, a few authorities are of the view that climate-related financial risks should be manifested or embedded into the existing risk categories (e.g. credit risk, operation risk, etc.), rather than be considered a new and standalone category of risk. Less than half of the Basel Committee members have issued dedicated supervisory guidance related to the governance, strategy and/or risk management of climate-related financial risks by banks. The form chosen to this supervisory guidance is guidelines, action plans or supervisory statements, and they are not always legally binding rules. Rather, it is principle-based or interpretations of existing rules. In addition to supervisory guidance, some institutions are working on identifying ‘best practices’ to mitigate climate-related financial risks and some of these initiatives are being conducted together with private-sector participants. Most supervisors have not yet included some form of the mitigation of climate-related financial risks into the prudential capital framework. However, some institutions are still quite far from being able to quantitatively assess the climate-related financial risks in the context of capital. As such, they have no short-term plans to consider applying Pillar 1 or Pillar 2 requirements for climate-related financial risks. Regarding the potential application of Pillar 2 capital add-ons, several institutions believe that the current Pillar 2 framework offers flexibility to address climate-related financial risks. Under Pillar 2, banks are required to develop the internal capital adequacy assessment process to capture all material risks that are not sufficiently covered under Pillar 1. Such risks would also include climate-related financial risks if they are estimated to be material to the specific financial institution.

The NGFS also provided a set of six recommendations to enhance the role of central banks, supervisors, policymakers and financial institutions in the greening of the financial system and the managing of and climate change and environment-related risks (NGFS 2019). Namely: (i) integrating climate-related risks into financial stability monitoring and micro-supervision; (ii) integrating sustainability factors into own-portfolio management; (iii) bridging the data gap; (iv) building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing; (v) achieving robust and internationally consistent climate and environment-related disclosure; (vi) supporting the development of a taxonomy of (environmentally sustainable) economic activities. These recommendations are not binding and reflect the best practices identified by NGFS members.

The labelling of sustainable securities, in particular if needed to drive policy making, is not a straightforward exercise and requires the implementation of a considerable preliminary infrastructure. In this respect, at least two main aspects need throughout consideration. The first concerns the analysis of sectors or activities that can be financed with “sustainable” or “green” funds. The second regards the operational standards (e.g. use of proceeds, management of proceeds, reporting requirements) that need to be followed for labelling a specific security as “sustainable” or “green”. For a further dissertation, see Berrou et al. (2019a) and, for the policy activities carried over at the European level in the attempt to mainstream sustainable finance by defining, inter alia, a taxonomy of sustainable activities and correlated labelling standards, https://​ec.​europa.​eu/​info/​business-economy-euro/​banking-and-finance/​green-finance_​en.

One can say that in some jurisdictions fostering sustainability should be already considered as a secondary objective of central banks and, as such, can be treated within the existing statutory functions. For example, the main objective of the European Central Banks (ECB) is to “maintain price stability”. Nevertheless, “without prejudice to the objective of price stability, the ECB may support the general economic policies in the Union. These may include, inter alia, full employment and balanced economic growth”.