Banking’s Climate Conundrum

“Climate change is an emerging risk to financial institutions, the financial system, and the economy,” Federal Reserve Chair Jerome Powell proclaimed in 2020. In doing so, Powell joined a growing chorus of policymakers, scientists, and scholars raising alarms about climate change’s potential to destabilize the global financial system. Around the world, financial regulators have begun implementing policies to address climate risks among banks, insurers, and other financial institutions. Despite Powell’s acknowledgement of climate risks, however, the United States lags significantly behind other countries in addressing such risks. My paper, Banking’s Climate Conundrum, argues that the United States’ sluggishness in responding to climate-related financial risk is problematic because the U.S. banking system is uniquely susceptible to climate change. It contends that the United States must act quickly to overcome this unusual weakness by taking bold steps to safeguard the financial system from the climate crisis.

The U.S. financial system’s vulnerability to climate change stems, in part, from a little-known provision in bank capital requirements. Capital requirements are bank regulators’ primary tool for protecting the safety and soundness of the financial system. Generally speaking, the more capital a bank maintains, the bigger the cushion the bank has to absorb losses, and the less likely the bank will become insolvent. The international Basel III capital accord established new global capital standards for banks in 2010. Under Basel III’s standardized approach, the amount of capital a bank must maintain for a corporate loan or a sovereign bond is based on the company’s or country’s external credit rating. Thus, a bank that makes a loan to Microsoft (with a AAA credit rating) is required to maintain less capital than a bank that makes a loan to American Airlines (with a B- credit rating), since the loan to Microsoft is less risky.

Under Basel III, banks’ capital requirements are sensitive to borrowers’ climate risks since credit rating agencies like S&P, Moody’s, and Fitch take into account issuers’ exposures to climate change. The rating agencies recognize that issuers face both physical risks—the increased frequency and severity of extreme weather events—and transition risks—regulatory and policy changes caused by the shift to a sustainable economy. The rating agencies reason that “brown” companies like Exxon and Chevron are more likely to default on their debt as weather events intensify and the global economy transitions away from fossil fuels. Thus, when a credit rating agency downgrades a “brown” company because of its climate risk—as S&P did to Exxon and Chevron in 2021—banks exposed to that company could have to maintain more capital in response.

The United States, however, has deviated from international capital standards in a way that ignores banks’ climate risks. After the 2008 financial crisis, U.S. policymakers were highly skeptical of the role that credit rating agencies played in the mortgage-backed securitization boom. In response, Congress adopted section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 939A prohibited all federal agencies—including the banking regulators—from referencing or relying on credit ratings in their regulations. Due to section 939A, the federal banking agencies were legally barred from implementing the Basel III standardized approach, which expressly relies on external credit ratings to assign capital charges for corporate and sovereign exposures. Instead, the United States’ post-crisis bank capital rules assign a flat risk-weight to all corporate exposures, regardless of the borrowers’ creditworthiness or climate risks.

Because of section 939A’s prohibition on the use of credit ratings, the U.S. banking system is uniquely susceptible to climate risks. In other countries that follow Basel III, when a credit rating agency downgrades a “brown” company, banks that lend to that company must compensate by maintaining a bigger capital cushion. In the United States, however, climate-related credit downgrades have no effect on bank capital requirements. Over time, this dynamic will likely incentivize “brown” companies to borrow more from U.S. banks, intensifying the U.S. banking system’s exposure to climate risks. At the extreme, herding by “brown” companies into the U.S. banking system could trigger another financial crisis.

Other countries—which are already better insulated from climate risks because they use credit ratings in their bank capital regulations—have begun implementing policies to further address climate exposure in their financial sectors. The Bank of England, for example, has conducted climate stress tests to assess banks’ and insurers’ vulnerability to climate risks. The European Central Bank (ECB) has published guidance establishing supervisory expectations for banks’ risk management of environmental risks. The Bank of Japan (BOJ), meanwhile, has committed to provide funds to financial institutions that support activities aimed at combatting climate change.

Despite the United States’ unique susceptibility to climate financial risk, however, U.S. policymakers have done little to address this vulnerability. After much prodding by climate activists, the Federal Reserve and other financial regulators joined the international standard-setting Network for Greening the Financial System in 2020, three years after the network was formed and after more than seventy other central banks and financial supervisors had already joined. President Joe Biden issued an executive order in May 2021 directing financial regulators to assess climate-related risks to the stability of the U.S. financial system. As mandated by the executive order, the Financial Stability Oversight Council (FSOC) conducted a review of climate financial risks. In terms of actionable outcomes, however, U.S. regulators have accomplished little to date.

My paper contends that it is imperative for the United States to address escalating climate risks in the financial system. Policymakers could choose from a wide array of policy options. For example, Congress could repeal section 939A and thus allow the banking agencies to re-incorporate credit ratings into their bank capital requirements. This approach, however, could expose the U.S. financial system to the same shortcomings in credit ratings that contributed to the 2008 financial crisis. Moreover, repealing section 939A might be politically infeasible due to legislative gridlock in Congress.

If lawmakers retain section 939A, regulatory agencies could adopt alternative strategies to address climate financial risk through climate stress tests, climate-related adjustments to capital risk-weights, or climate risk capital surcharges. These alternative strategies are worthy of consideration even if Congress were to repeal section 939A. Indeed, while reincorporating credit ratings into bank capital requirements would enhance the regulatory framework’s climate risk-sensitivity, credit rating agencies might underestimate issuers’ climate-related risks and thus leave the banking system underprepared, absent additional climate-sensitive capital adjustments.

Regardless of which policies the United States chooses to implement, it must do something. The strange quirk in U.S. law that prevents the banking agencies from relying on external credit ratings when setting bank capital requirements renders the U.S. financial system uniquely vulnerable to climate risks. This idiosyncrasy makes it all the more troubling that the United States lags other countries in implementing climate safeguards for its financial system. It is critical, therefore, that policymakers address this shortcoming before it is too late.

The complete paper is available for download here.