Central Banks Must Upgrade Their Risk Management
By: Pierre Monnin
An adapted version of this article was originally published (in French) by Le Monde here.
The COVID-19 crisis is a stark reminder of how sharply asset values can shift. Amid a crashing demand for oil and gas, giant energy companies like BP, Chevron and Shell massively wrote down the value of their assets. And those that did not, like Exxon, are now facing the prospect of lawsuits.
Beyond the COVID-19 pandemic, the looming climate crisis will also significantly reshuffle asset values in the next decade. Energy stranded assets are a case in point. Some estimates indicate that one-third of the current value of big oil and gas companies would evaporate if Paris Agreement goals are achieved. Investors must absolutely reflect this outlook in asset valuations to mitigate future losses.
Central banks are no exception. Given the size and speed of expansion of their balance sheets, it is even more imperative to make sure that their assets are valued correctly. Taking climate change into account in central banks’ asset valuation practices is a key step to achieve that.
On this front, the situation thus far is alarming. The Central Banks and Supervisors Network for Greening the Financial System (NGFS), a group of 70 central banks and supervisors across the globe have repeatedly warned that climate financial risks are far-reaching in breadth and magnitude, and that they are foreseeable and irreversible.
Yet climate risks are not sufficiently accounted for by financial markets and by rating agencies as highlighted by NGFS members on several occasions. This concern is shared by the European Systemic Risk Board (ESRB), which reported in July that “financial market pricing of climate risks appears heterogeneous at best, and absent at worst”.
Financial markets’ failure to adequately price-in climate risk has dire consequences for central banks. Since, as underscored by the NGFS, “climate- or environmental-related criteria are not yet sufficiently accounted for in internal credit assessments or in […] credit agencies’ models which many Central Banks rely on for their operations”, central banks’ balance sheets will thus be exposed to unwarranted losses when climate risks materialize.
Against this background, the NGFS recommends that “central banks assess the implications for risk management practices, as climate-related shocks may affect the riskiness of their financial portfolios and market operations.” Financial tools accounting for climate risks in asset valuation do exist. Even if they cannot yet achieve the same degree of precision as traditional risk assessment tools, the information they provide should not be discarded by central banks. Updating central banks’ risk management frameworks to account for climate risks is possible and is an urgent step that needs to be taken.
In fact, not revising central banks’ risk management practices to account for climate risks would be alarming. In the context of a large bank, it would be akin to having the Governing Board pointing to significant risks ahead but deliberately not acting to mitigate them and protect the bank’s balance sheet. Such a situation is unimaginable in the case of a commercial bank, and by the same token should be unacceptable for public institutions like central banks.
Christine Lagarde, President of the European Central Bank (ECB), has repeatedly declared her intention to address this issue. She stated, for example, that the ECB should re-examine its collateral framework to ascertain that loans pledged by commercial banks in exchange for funding are valued correctly, taking climate risk into account. Jens Weidmann, President of the Bundesbank, Francois Villeroy de Galhau, Governor of the Banque de France, and other representatives of Eurozone central banks have made similar declarations.
Tackling the climate crisis however requires actions rather than words. As highlighted by the NGFS again, “the magnitude and nature of the future impacts [of climate change] will be determined by actions taken today.” Central banks need to start acting urgently. Any further delay will only make an early and orderly transition to an environmentally sustainable economy less likely. The alternative — a too late and too sudden transition or no transition at all — is a much worse outcome for the financial sector, as the ESRB warned central banks four years ago already.
The ECB has indicated that it will review its risk management practices, including climate risks, within the strategic review that it launched at the beginning of the year. Since then, its balance sheet has expanded significantly as a result of the monetary measures introduced in response to the COVID-19 crisis. The expansion of ECB’s balance sheet reinforces the need for state-of-the-art risk management. Ensuring that this expansion accounts for climate risks is imperative.
It is time for central banks to upgrade their risk assessment software and properly integrate climate risks in managing their monetary policy portfolios.