Financial Regulators Must Act to Prevent a Climate-Related Crash

The 2008 global financial crisis and the recent federal intervention at Silicon Valley Bank taught us that federal regulators must monitor bank risk taking and intervene early to prevent threats to financial stability. Failure to take timely action led to past financial crashes with their vast array of harms—business failures, mortgage foreclosures, and taxpayer bailouts.

With climate change now widely recognized as a threat to financial stability, financial regulators must uphold their statutory duties by acting now to head off a climate-related crash.

Another lesson that emerged from 2008 is that “non-bank” financial institutions, such as insurers and asset managers, can create just as many problems for the financial system as chartered banks. After all, the subprime mortgage market that drove the 2008 crisis was dominated by non-banks.

In the aftermath, Congress established the Financial Stability Oversight Council, directing it to identify non-banks that pose risks to financial stability and place these institutions under the Federal Reserve’s supervision.

Financial regulators, well-aware of this historical backdrop, should therefore be alarmed by recent news about non-bank exposure and contributions to climate-related financial risk. Citing climate-related disasters, in the past few weeks alone State Farm and Allstate abandoned the California homeowners insurance market, and Farmers departed from Florida. These are just the latest in a long line of climate-linked disruptions of the insurance market.

Fifteen property insurers have gone insolvent due to climate-related disasters in Florida, homeowners across the country are experiencing soaring premiums and pullbacks on coverage, and public insurance funds lack the resources to cover the gaps.

Experts say today’s climate risk is destabilizing the entire property insurance sector. The Treasury Department’s Federal Insurance Office also flagged the need for regulatory attention to this issue, highlighting the “limited” efforts to date.

Other components of the non-bank sector, such as publicly traded asset managers and private equity funds, are likewise threatened by, and contribute to, climate risk. Housing finance is just one of their many business lines facing threats due to climate change. Many asset managers are also badly prepared for the rapid economic transition away from carbon-intensive energy sources. Estimates of the size of this dangerous “carbon bubble” of mispriced assets, subject to the rfapid deflation that leads to a financial crash, range from $1 trillion to $4 trillion.

The non-bank sector can start addressing this problem by reducing its own contributions to climate risk. A Sierra Club and Center for American Progress report estimated that in 2020, 10 US asset managers provided more than $27.3 trillion in fossil fuel financing, an estimate deemed conservative due to lack of comprehensive disclosures.

A 2023 study by Reclaim Finance and partners shows that despite ambitious climate pledges, top US and EU asset managers are continuing fossil fuel financing unabated, with minimal efforts to engage portfolio companies on decarbonization strategies.

Insurance companies are also contributing to financial stability risk through fossil fuel finance. Last year, a study by the California Department of Insurance found that the insurers it regulates hold portfolios with $538 billion in fossil fuel investments.

Last month, the Senate Budget Committee sent letters to seven insurance companies demanding disclosures about how they underwrite, invest in, and profit from the fossil fuel industry, and their plans, if any, to reduce these financed and insured emissions.

Although the federal government has begun taking halting steps to address climate risks at chartered banks, 2019 policy guidance limited its ability to act on non-banks. Despite a clear mandate under the Dodd-Frank Act for FSOC to address financial stability risks from non-banks, the Trump administration crafted that guidance to effectively block FSOC from placing non-banks under federal supervision.

Meanwhile, market changes have led to a regulatory gap worse than the one that existed prior to the 2008 financial crisis, when the non-banking sector was less than half the size of the banking sector.

Today, at $18 trillion, the non-bank financial sector is nearly the same size as the $23 trillion banking sector. If the non-banking sector continues to escape federal oversight, it will continue to expand without taking precautionary measures on climate risk, posing an ever-growing threat to financial stability.

The good news is that in April, FSOC called attention to the financial stability risk posed by the non-banking sector and proposed guidance to remove the Trump-era roadblocks to federal oversight. FSOC should quickly finalize this guidance and then begin designating as “systemically important” any non-bank that poses a significant risk to financial stability.

In prioritizing designations, it should focus on insurance companies, asset managers, and other non-banks creating financial instability due to large-scale fossil fuel financing.

What happens next is in the hands of the Federal Reserve, which must demonstrate it truly understands the myriad, complex, and interconnected risks posed by climate change. So long as greenhouse gases continue to accumulate in the atmosphere, the risk to people, businesses, and financial stability will continue to grow.

It’s time to heed the lessons of 2008 and the recent disruptions of the insurance market, and develop clear-eyed solutions to the financial stability risks posed by climate change. This can be achieved only with a regulatory focus on the central driver of climate risk: greenhouse gas emissions and the financing of projects that increase them.

In the face of growing climate risk, FSOC and other federal regulators must act now, before climate change contributes to a crash of the financial system and our economy.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

John Kostyack is an adviser to the Sierra Club’s Fossil-Free Finance campaign and former executive director of the National Whistleblower Center and the Wind Solar Alliance.

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