President Biden’s May 20 executive order on the financial risks of climate change makes clear that banks will be a key focus of the administration’s climate policy. Already, the administration has begun pressing financial institutions to increase their climate-friendly lending and financing activities.
Yet financial institutions have been ahead of the curve in taking their own steps to aid the climate transition process. Policymakers should not expect banks to offer a complete solution to an ever-changing, government-driven list of climate challenges, and they should especially resist the urge to criticize banks if they think their efforts do not go far enough, fast enough.
While financial institutions cannot make risk disappear, they are expert in risk transfer. They can create and deploy novel financial products to transfer risks in ways that facilitate climate transition.
That is especially true when financial institutions take on risks that originate outside the financial system, like climate risks arising from industrial and commercial activities. But, transferred risks are not eliminated risks—risks always wind up someplace.
To start, those risks will appear on financial institutions’ balance sheets because, in a very real sense, they are converting the “real” economic risks of climate change into “financial” risks associated with green finance and lending activities. Financial institutions are rarely content to leave risks on their books, at least not without seeking to hedge them in some way. This much is clear from a few simple examples.
A lender can mark up a loan that has embedded rate discounts for meeting decarbonization targets. If one or more targets are hit, the interest rate would be reduced to a “normal” level for what the lender would charge if the loan were carbon-agnostic.
The borrower will want to offload the risk of not hitting the climate target someplace else. A lender can instead price a loan to start at a carbon-agnostic rate and work down from there if the borrower hits one or more decarbonization targets. Here, too, the lender will want to offload the risk of taking those haircuts and receiving less loan income.
Now imagine performing this exercise at scale, across entire loan portfolios that cover different industries and span jurisdictions that treat green finance differently. Risk hedging will be difficult given these complexities.
Futures and other standardized derivatives may help, however ill-suited, but that is just a risk transfer via a derivatives exchange. Bilateral transactions such as swaps can better address more bespoke risks, but that too is risk transfer not risk elimination.
There is no magic wand to wave that will make these risks disappear. As a result, policymakers need to signal clearly to financial institutions how transactions that transfer climate risk will be treated. This extends to the risk management by financial institutions.
Sticks and Carrots
Recent reports of bank examiners challenging financial institutions, in real time, about how they risk-manage climate change are troubling. These reports suggest that regulators may be taking a “ready, fire, aim” approach, one that may lead to political plaudits and media acclaim. But regulatory oversight and risk management work best when they both key off standards that have been fully considered and delivered to financial institutions with sufficient lead time for them to address potential compliance gaps.
Rather than using these kinds of sticks, policymakers should use carrots instead. In our experience, they work much better than sticks—particularly where financial institutions and regulators can be aligned on climate-related goals despite their different incentives. Why punish financial institutions for acting in the public good, when that’s what regulators should want?
Carrots that make sense include favorable capital treatment and reduced margin or collateral requirements for transactions that reward borrowers for reducing their carbon output.
Moreover, transactions that offload the associated costs of green finance should not be penalized. Not only do those offloading transactions help establish a price for climate risk transfer, but that pricing information is valuable to market participants, as well as to policymakers that must consider whether their climate measures are effective.
Offloading to a Green ‘Bad Bank’
Policymakers should also encourage creative thinking to help financial institutions understand how to identify and channel these risks, including the potential for a green “bad bank” where offloading transactions can be placed. Such a mechanism would enable market participants to engage in even more offloading transactions, which will remain a vital corollary to green finance as financial institutions work through their loan portfolios.
This approach has been used in the past to manage liabilities associated with distressed or nonperforming assets. In this context, the bad bank could be a joint industry effort or a public-private partnership in which carbon-intensive assets can be transferred in exchange for fresh capital, which financial institutions can use to support additional green lending and finance.
The financial system transmits risks and, at times, mitigates or amplifies them. It cannot make risks go “poof.” What it can do is facilitate the transition to a greener economy using creative financing solutions. Policymakers, international bodies, and other stakeholders should recognize this fundamental point as they evaluate what role financial institutions play in climate policy.
Climate risk will only be reduced by decreasing carbon output in the broader economy. That is a job for elected officials, and it will require them to put hard choices to a public that will bear the associated costs. To expect that financial institutions can single-handedly reduce climate risk is unrealistic. The sooner that idea goes “poof,” the better.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Joshua B. Sterling is a partner in the Financial Markets practice at Jones Day and is based in the firm’s Washington, D.C., office. He has 20 years of experience in the derivatives and securities markets, both as lead counsel to major companies and as a senior federal financial regulator. He represents clients before the Commodity Futures Trading Commission, SEC, and various self-regulatory organizations. Prior to joining Jones Day, Josh was director of the CFTC’s Market Participants Division.
Amanda L. Dollinger is an associate in Jones Day’s Financial Markets practice and is based in the firm’s New York office. Her practice centers on representing financial institutions in connection with residential mortgage-backed securities, collateralized debt obligations, and other structured financial products.
The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.