Banks' role in Carbon Risk Management

According to an article published in the December 14th, 2019 issue of The Economist, some national supervisors have started including climate risk in their assessments of banks and insurers. The new President of the European Central Bank (ECB), Christine Lagarde, would like the bank to be 'greener'. Other central banks too are concerned about the impact of climate change on financial and economic stability. And rightly so. However, activists are going one step further and arguing that it is not sufficient for central bankers to merely take climate risk into account in their analyses, but they should take proactive steps like shifting capital away from polluters towards greener entities, thereby tackling the issue head on. The question is whether this isn't a bit too much to ask of bankers.

Credit Risk Management in Banks

What should Banks be on the guard against? Exposures to borrowers who are exposed to problems associated with climate change, or exposure to borrowers who contribute to these problems? If you view this question from a pure credit risk management point of view, the answer depends on what Banks see as the risk: Climate change, or possible penalties imposed on polluting firms. Climate change can create issues for lenders. For instance, floods caused by climate change can reduce the value of mortgage books of the Bank. On the other side, heavy carbon taxes too can affect Banks adversely if some polluting firms get into financial troubles because of the tax/penalties.

Thus, it appears that there are two factors to be considered: the investment horizon and the probability of heavy carbon taxes being implemented in the jurisdictions in which a Bank operate. Talking about the horizon, we must remember John Maynard Keynes’ assertion “In the long run we are all dead”. A practical Banker would be more concerned about the short and medium term, especially if the loan tenure is not very long. Hence, although climate change is going to strike, and to deliver a devastating blow at some point of time in future, it appears that the immediate risk is not change in climate, but change in climate policy. Atleast The Economist appears to believe so. They have set the two statements "Climate-related disruption could affect productivity and long-term economic growth, with consequences for interest rates" and "Central bankers in commodity-producing countries such as Norway and Australia note that a shift from polluters would alter the structure of their economies" together in sequence, that it is quite clear that the climate related disruption that they are talking about is that caused by policy change. Again, much depends on the national governments' agenda related to tackling the carbon issue. We still do not have uniformity in this area on a world-wide basis. In countries where the governments are aggressive on this front, there is a clear and present danger for the lenders. They have to immediately address the climate risk issue if they are not doing so already.

The need for a carbon policy

There cannot be any doubt that carbon emissions are to be controlled. The only disagreement is whether Bankers are the right people to bell the cat. According to The Economist, "if governments want to penalise polluters they can do so directly with taxes, or by empowering new environmental bodies. There is no need to muddy the waters over the responsibilities of central banks."

In fact, there are instances in India itself, where the Banking regulator has made policy changes that are not in line with the spirit of prudent risk management. Precisely at the time when the Indian economy is not performing well and unemployment/job losses are rising, RBI reduced the Risk Weight for consumer credit (including personal loan but excluding credit card receivables), from 125% to 100%. I don't think even RBI will claim that the rationale behind this move is a perceived reduction in riskiness. On the contrary, the general perception was that Retail had become more risky than before, owing to job losses and failures of small businesses. Hence, the reduction in Risk Weight was flawed on two fronts: Firstly, it will reduce the capital requirement when in fact the economic situation is demanding an increased cushion of additional capital support to absorb the expected losses. Secondly, it might prompt lenders to lend more to the consumer sector at a time when a prudent banker should actually be more conservative. In fact RBI is admitting as much, when it is mentioning in its REPORT ON TREND AND PROGRESS OF BANKING IN INDIA 2018-19 that "the possibility of defaults among retail segments rises as growth slows down" and that "household leverage and indebtedness need to be kept in focus in the context of overall financial stability".             

Another instance is that of relaxations in the exposure ceiling for lending to single NBFCs (other than Gold Loan companies) and the decision to risk-weight NBFC exposures based on external rating grades. The former measure was an obvious attempt to provide liquidity to NBFCs. Although the objective is noble, it is a fact that NBFC as a sector is not doing well at present and Banks will do well to be careful while lending to NBFCs. The decision to risk-weight NBFC exposures based on external rating grades is, on the face of it, a welcome step, as capital would now have to be earmarked based on risk perception rather than at a flat rate. But this would mean that risk weight for exposures to the relatively stronger NBFCs will come down from the flat level of 100%. And it is a contradiction that exposures to these same NBFCs used to be risk weighted at 100% during sunny days when NBFC exposures were considered a rather safe bet.

In fact, RBI in a statement on development and regulatory policies, mentioned that it is with a view to facilitating flow of credit to well-rated NBFCs, that it has been decided that rated exposures of banks to all NBFCs, excluding Core Investment Companies (CICs), would be risk-weighted as per the ratings assigned by the accredited rating agencies, in a manner similar to that for corporates. Thus, it becomes obvious that, the move was primarily aimed at tackling the liquidity crunch situation that the NBFCs found themselves in, and was not a measure aimed at better risk management from the banks' perspective.

Difference between the Indian example and the proposed climate risk control measure

The Indian examples mentioned above are pertaining to measures undertaken by RBI to improve the general health of the economy. Economy was moving downhill, consumer sentiments were getting affected and consumer spends were decreasing. This did have the potential to kick off a vicious cycle of firm failures, further job losses and even more reduction in consumer spending. And Banks would have become affected, directly and immediately. As far as the NBFC crisis was concerned too, Banks would have got affected badly, if more NBFCs started experiencing stress owing to withdrawal of funding support from Banks. Thus, one can argue that the RBI measures were calculated risks aimed paradoxically at reducing the 'bigger' risks! From a Bloomberg report dated 26-11-2019 it appears that China is experiencing the same dilemma. Their economy is growing at the slowest pace in almost three decades, cooled inter-alia by a crackdown on risky lending. Recent government efforts to boost growth threaten to lead to a pileup of bad debt. The Chinese central bank said that it should “stay cool-headed” to keep a balance between economic growth and risk control.

Individual Indian banks can manage their risks better, if they adopt a 'wait and watch' approach to Consumer Loans and NBFC exposures. But the assumption here is that other Banks continue to lend thereby rescuing the economy. This is clearly unethical if we go by Immanuel Kant's first formulation of the categorical imperative. The First formulation asks to "Act only on that maxim through which you can at the same time will that it should become a universal law." Simply put, you are not expected to do anything that you would not be willing to allow everyone else to do as well. Kantian ethics does not allow you to make exceptions for yourself.    

The climate case is different, as far as immediacy and clarity are concerned. It is not clear when it is going to strike the Banks decisively. And the manner in which the risk is going to spread in the system is also unclear. It is quite possible that the polluters get compensated (in one way or the other) for stopping pollution. It is also possible that no compensation is awarded, and a consequent re-distribution of income takes place. The doomsday prediction too can come true if governments do not heed to Yual Noah Harai's call for a concerted global effort to address the triple concerns of Artificial Intelligence, Nuclear War and Climate Change. At the moment, anyway, the climate change scenario is quite unclear and Banks would do well to keep off this area, and leave the field to the experts.           

(Views expressed are personal)