The purpose of this article is to answer the following questions:
- Is there is some linkage between climate and financial stability & crises?
- What is existing coverage for banks’ risks due to environmental issues under BASEL II & III?
- Can environmental hazards be added in bank’s overall borrower’s risk assessment including its modelling?
One of the functions of any financial system is to channel adequate finance to those investment opportunities which can benefit societies in the long run. But to achieve long-term sustainable growth, the Earth’s planetary boundaries should be considered as ‘safe operating limits’ which if crossed can result in hasty, unalterable and damaging environmental consequences for the world’s population. In a UN study, environmental costs are increasingly becoming ‘Material’ financially, as yearly environmental costs from global human activity (US$ 6.6 trillion in 2008 – 11% of world’s GDP are projected to go up to US$ 28.6 trillion in 2050 – 18% of world’s GDP).
Several attempts have been made to find a connection between climate and financial system/markets/crises; however, there is still a lack of pragmatic research conclusions in this area. Some notable historical examples are:
- Sir William Herschel (1801), renowned British astronomer who discovered Uranus, in his monumental paper attempted to link sunspot activity and wheat price in England.
- William Jevons (1884) famously suggested a linkage between sunspots and financial crises due to poor agricultural produce and ultimately a strain in the financial sector.
- During late 19th and early 20th century, USA witnessed dust bowls due to prolonged severe drought and intensive land use (i.e., unsustainable farming). It created an economic recession which in turn catalysed individual banks’ losses and a source of systemic risk for the regional economy.
- The rise in insurance payouts (generally referred to as ‘losses’) due to global natural catastrophes. The number of registered weather-related natural hazard loss events has tripled since the 1980s, and inflation-adjusted insurance losses from these developments have increased from an annual average of around US$10 billion in the 1980s to around US$50 billion over the past decade.
- There has been an increase in hurricanes activity in Atlantic and Caribbean region over last one century. One of the phenomenon’s reasons, though arguable, is ‘Global Warming’. These hurricanes leave banks with displaced staff & customers, shortage of cash & acute bank runs, power outages, costs/penalties due to disruption of services, heightening of banks’ mortgage & infrastructure portfolio credit risk due to hurricane-related damage/liabilities/expenses for bank funded/collateralised properties/projects.
- Great Kanto Earthquake of 1923 is considered a cause for 1927 Showa Financial Crisis in Japan.
BASEL I accord (1988) does not mention any environmental risk specifically. Though under para 510 of Pillar I of BASEL II & III (2004 & 2010-11), banks are required to assess and monitor the impact of specific environmental risks which can affect borrowers through deterioration of property/collaterals or give borrowers some form of liability. However, no macroprudential or portfolio-wide environmental risk assessment or monitoring is devised for banks on even individual level. To meet BASEL III LCR threshold requirements, banks are more inclined towards selling off existing long-term environmentally sustainable project financing & may offer limited future finance supply to such ventures. While another new BASEL III requirement is NSFR, which requires banks to fund most of the illiquid long-term finance (such as these projects) with long term customer deposits and long-term bonds, both of which come with higher interest rates compared to short-term rates, resulting in relatively higher costs for these environmentally sustainable projects. To meet these new requirements under BASEL III’s implementation timeline, some big banks have already started unloading project finance from their portfolio on a massive level while others are trying to reduce tenor for existing loans. Some bank practitioners, however, feel that introducing regulatory incentives to benefit some environmentally sustainable economic activities, due to more political, credit, liquidity, operational, market and economic risks compared to short-term corporate lending, can create some adverse compromise situation between financial stability & environmental security.
Any bank’s environmental risks exposure is a derivative of these factors:
- Size/Nature of Transaction/project to be financed
- Tenor of facilities
- Nature of Security/Collateral offered
- Other Terms & covenants of facility
Bank (both relationship & risk management teams) should implement the following design for inclusion of environmental exposure in client’s risk rating:
- Pre-disbursement environmental screening – To identify & document the level of risk, i.e., High, Medium or Low. Same will enable the bank to go further towards credit appraisal stage with defined minimum level of risk management activity.
- During credit assessment stage, reports of site visits, valuation reports, feasibility studies & project environmental audits will be completed. Same will enable a bank to discount client proposed/existing Obligor Risk Rating (ORR) & Facility Risk Rating (FRR) with an Environmental Risk Rating (ERR) to provide a modified ‘Real’ FRR.
- Proceeding to stage 3, i.e., credit review and approval stage. Some should subject to zero or mitigable environmental risks from the transaction/project. Moreover, environmental covenants (including reporting/monitoring requirements) can be specified as per the direction of bank’s credit approving authorities.
- Post disbursement monitoring and compliance- Bank should obtain following from client on regular basis:
- Submission/Reporting to environmental authorities including those under certifications or other periodic reporting.
- Material incidents of environmental non-compliance including fines, penalties, notices, etc.
- Any event material to bank’s security/collateral deterioration, though same meets regulatory authorities’ requirements.
During credit assessment phase (point 2 above), a bank has to assign environmental discount on proposed/existing client FRR derived through financials, etc. This ‘discount’ will provide the bank with stressed conditional modified ORR+FRR of the client can enable a bank to identify required level of capital & pricing for project/transaction. An overview of this design is given below with help of a hypothetical example beneath it:
* Stress results can be high, medium, or low depending upon regions, technologies used, other environmental liabilities/compliance issues, identified during site visits and environmental audits, etc.
** ‘Modified Rating’ & ‘Re-modified Rating’ cover Micro-prudential risks. While ‘Final Rating’ covers externalities and systemic risks also.
Testing shows how a bank’s portfolio-wide PD increases from BBB to BB in micro-prudential risks scenario & to CCC in the case of macro-prudential risk scenario. Same can enable a bank to more accurately monitor, manage (e.g., through better securities, more flexible pricing and other loan conditions, e.g., high cash requirements) and insure against its exposures both industry wise and region wise to avoid potential losses.