Regulators must act to protect financial system from climate risk: report

Federal regulators must act quickly to require banks to insulate themselves and their customers against the potentially ruinous financial effects of both climate change and the energy transition, a new report by Public Citizen and Americans for Financial Reform found. 

The report is a wish list of policies that the two groups are putting out in advance of a key report on climate risk in the financial system from the Financial Stability Oversight Council (FSOC), which was mandated by a May executive order from President Biden.

In that report — which was originally scheduled for November but has been moved up to next week — Treasury Secretary Janet Yellen, who serves as chair of the FSOC, is expected to recommend some form of mandatory climate risk disclosure.

This is the idea, echoed by Securities and Exchange Commission Chairman Gary Gensler and Sen. Elizabeth Warren (D-Mass.), that banks and publicly traded companies should have to notify investors and regulators about how exposed they are to the effects of both climate change and the potential consequences of a rapid loss of confidence in fossil fuels.

But disclosure alone is not enough to avoid the possibility of an “Emperor’s New Clothes moment” of sudden disenchantment with fossil fuels that could crash the financial system, said report co-author Yevgeny Shrago of Public Citizen.

The Biden administration has announced plans for the United States to reach net-zero emissions by 2050 amid a groundswell of investment and enthusiasm in industry and investment for electric vehicles and renewable energy that threatens a sudden loss of confidence in fossil fuels, Shrago noted.

“If we need to stop burning fossil fuels by 2050, you don’t want to own them in 2049, and if not in 2049, then probably not in 2048, and so on.” 

“So will there be a moment where everyone goes, ‘All these [fossil fuel] reserves are worthless, there’s no reason to keep producing them,’ where it triggers a fire sale, drives assets down and drives companies out of business? That can underpin a lot of exposure that banks have.”

Disclosure of that risk is critical, Shrago said — but it is no more sufficient to solve the underlying process than it was during the lead up to the 2008 financial crisis.

During the frenzy of trading in tainted mortgage-backed securities and credit default swaps that characterized that bubble, actors across the financial system took actions they knew to be risky and potentially destructive to the system as a whole — because those actions were still in their temporary or personal self-interest, Shrago said.

“In 2008, more disclosure wasn’t the answer — we needed more oversight of risk taking,” Shrago said. 

As such, the report urges federal regulators to follow in the steps of those in the United Kingdom and European Union and require American banks to conduct “climate stress tests,” carefully auditing their portfolios to various potentially disastrous scenarios, like major natural disasters or a sudden loss of confidence in fossil fuels, and begin to take steps to become more resilient to them.

For example, if they are going to continue investing in fossil fuels, banks might defray that risk with greater investment in renewables to reduce their vulnerability to “transition risk.”

Over the long term, Public Citizen and Americans for Financial Reform want the regulators to require banks to use that information as the foundation for a more forward-looking, resilient financial system. 

As such, some of the steps they recommend go against the immediate financial interest of shareholders and management but which could insulate taxpayers — and the system as a whole — from potential collapse.

One such longer-term recommendation is to raise the requirement for how much capital banks making investments deemed to be risky must have on hand — and that they do this by issuing more shares, not taking in more deposits, which is to say debt.

Neither management nor shareholders like to do this because it dilutes share price Shrago said — another place where short- and long-term incentives are out of alignment.

Banks must “make sure that if they’re holding more risky assets, they’re raising money from shareholders to cover those riskier assets, so if they are wiped out, the shareholders are the ones who lose and not debt holders — who are which implicitly depositors, which is implicitly the U.S. government” which guarantees those deposits through the Federal Deposit Insurance Corp., Shrago said.