“We need to ensure resilience to climate-change risk”

Interview with Frank Elderson, Member of the Supervisory Board of the ECB, Supervision Newsletter, 15 May 2019

Frank Elderson, Executive Director at De Nederlandsche Bank and Chair of the Central Banks and Supervisors Network for Greening the Financial System (NGFS), who joined the ECB Supervisory Board in 2018, talks about the risk climate change poses to financial institutions and how supervisors can help strengthen resilience.

Climate change is a hot topic across the globe, including in the financial sector. Why should the financial sector care and why should supervisors care?

Global warming affects all of us. The catastrophic effects of climate change are already visible around the world. Overall, worldwide economic costs from natural disasters exceeded the 30-year average of USD 140 billion per annum in seven of the last ten years. Since the 1980s, the number of extreme weather events has more than tripled. Extreme weather events affect health and damage infrastructure and private property, reducing wealth and decreasing productivity. These events can disrupt economic activity and trade, create resource shortages and divert capital from more productive uses in, for example, technology and innovation, to reconstruction and replacement. Uncertainty about future losses could also lead to higher precautionary savings and lower investment.

Climate change is also a source of financial risk, as it could result in physical and transition risks that could have system-wide negative impacts on financial stability and macroeconomic conditions. Over the next decade, carbon emissions must be reduced by 45% in order to reach net zero by 2050. This requires a massive reallocation of capital. If certain companies and industries fail to adjust to this new world, they will cease to exist.

But this transition also brings opportunities, as it should mainly be financed by the financial sector. For example, it increases the demand for green products and advice. Not seizing these opportunities could adversely affect the long-term viability of a bank’s business model. Financial institutions are therefore encouraged to take a long-term, strategic approach in considering these risks, and to embed them in their day-to-day governance and risk management frameworks. Our role as supervisor is to ensure that the financial sector is resilient to climate-related risks.

Should banks focus more on green finance in their investment strategies and business models?

We encourage banks to take a more forward-looking approach. Assessing not just traditional financial factors but also sustainability factors such as assets’ exposure to climate change can improve firms’ understanding of long-term risks and opportunities and enhance the risk-return profile of long-term investments. Given that sustainability factors can pose financial risks, banks should seek to better understand those factors. When risks and opportunities become more apparent through this long-term approach, a greater focus on sustainable finance may emerge naturally.

Scenario analysis and stress testing can be important tools to embed this long-term perspective by helping determine the extent of disruption to current business models in various sectors. Of course, the results might be sensitive to the assumptions underlying these exercises: the speed of the transition, investors’ and consumers’ preferences and other economic factors like interest rates, for example. But they can still provide us with insights into the risks involved and the general direction and scale of change.

What can banking supervision do to help reduce financial risks resulting from climate change? Do we need more regulation for banks specifically with regard to climate risks?

The Central Banks and Supervisors Network for Greening the Financial System (NGFS), which consists of 36 central banks and supervisors worldwide, has acknowledged that climate-related risks are a source of financial risk and jointly endorsed the call for action – now. Central banks and supervisors have a substantial role to play in addressing climate-related risks. It is up to us perform that role, and to deliver results. Climate change should be seen as a driver of traditional risk categories like credit and market risk and should be encompassed in current regulatory frameworks. Even though there are no regulatory provisions explicitly governing sustainable finance, banks and regulators should incorporate it in their daily activities. The absence of regulation isn’t an excuse not to take action.

That said, new climate-related legislation could help achieve these goals. For example, the European Commission has called for a unified classification system – a taxonomy – on what constitutes sustainable economic activity, as well as regulation on disclosure relating to sustainable investments and sustainability risks. These proposals could have a major impact on the way financial institutions run their business. For instance, banks, insurance companies and others might have to label their assets according to newly-developed standards. And this is not some distant future vision.

Finally, understanding how structural changes affect the financial system and the economy is key to fulfilling these responsibilities. Supervisors should build in-house capacity and collaborate with supervised institutions, each other and wider stakeholders to improve their understanding of how climate-related factors translate into financial risks and opportunities.

You have been Chair of the NGFS since 2018. What has the Network achieved so far and what’s on the agenda for the coming years?

As can be seen from the NGFS progress report published in October 2018, all members and observers have acknowledged that climate-related risks are a source of financial risk. So it falls squarely within the mandates of central banks and supervisors to ensure that the financial system is resilient to these risks.

In our first comprehensive report, published on 17 April 2019, we built on this and issued six recommendations. The first four apply to the work of central banks and supervisors while the last two are addressed to policymakers. However, all six call for collective action and focus on integrating and implementing previously identified needs and best practices for a smooth transition towards a low-carbon economy. These recommendations are intended to inspire central banks and supervisors – NGFS members and non-members alike – to foster a greener financial system.

The achievements of the NGFS and its rapid expansion within a year to 36 central banks and supervisors and six observers have exceeded my expectations. In 16 months, the NGFS has evolved into an effective platform to exchange experiences and cooperate closely with other stakeholders.

However, we are not there yet. These recommendations represent only the Network’s first steps. We still need a significant amount of analytical work to equip central banks and supervisors with the appropriate tools and methodologies to identify, quantify and mitigate climate risks in the financial system. So, future deliverables include a number of technical documents on (i) climate and environment-related risk management for supervisory authorities and financial institutions, (ii) scenario-based climate risk analysis, and (iii) incorporating sustainability criteria into central banks’ portfolio management. Going forward, the NGFS also expects to dedicate more resources to the analysis of environmental risks.

We need to take action, but we cannot do this alone. We need to cooperate globally with policymakers, the financial sector, academia and other stakeholders to distil best practices in addressing climate-related risks.

One NGFS principle encourages central banks and supervisors to “lead by example”. Do you have examples of how the Dutch Central Bank (DNB) takes the lead in addressing climate risks?

One way to ensure that climate risks are taken into consideration across the financial system is to support internal and external collaboration. In 2016 DNB established the Sustainable Finance Platform to promote and increase awareness of sustainable funding in the financial sector. Another aim is for participants – the financial sector, supervisory authorities and government ministries – to work together in developing risk management methodologies, scenario analyses and sustainability initiatives. In my view, this is a very effective way to facilitate pioneering, promoting and partnering, and it also builds our own capacity in these areas.

We also asked the banks directly supervised by DNB to submit a climate risk self-assessment as part of their Supervisory Review and Evaluation Process submission. I hope we can use the progress made with those banks to inform European banking supervision’s approach to significant institutions.

In addition, we performed a stress test last year to quantify the consequences of a disruptive energy transition for financial stability. The outcome indicated that a disruptive transition could lead to substantial losses for the Dutch financial sector. Governments can prevent unnecessary costs by implementing timely and effective climate policies. Financial institutions can curb energy transition-related risks by integrating them into their risk management.

But we also looked beyond climate risk. Our research found that the Dutch financial sector is exposed to other environmental and social challenges too. Water stress, raw material scarcity, biodiversity loss and human rights controversies also present risks through similar channels to those we identified for climate-related issues. Our task as supervisor is to act on these findings. This is something that the NGFS is planning to further explore in the coming years.

Finally, we intend to practise what we preach. By signing the United Nations Environment Programme’s Principles for Responsible Investment – and we were the first central bank to do so –, we have undertaken to integrate environmental, social and governance principles in our investment practices.

The Dutch supervisory authority has included psychologists in its supervision practices to assess top executives and board members in banks. How do you view this experience?

In 2011 DNB started with the supervision of behaviour and culture. The aim of this type of supervision is to identify the behavioural root causes of persisting supervisory problems. For example, with our board effectiveness examinations we look for behavioural patterns that may distort executive decision-making. These examinations reveal, for example, that the absence of critical challenge within the boards of banks is often caused by group pressure to conform to the majority opinion or by unmanaged conflicts between board members.

In the supervision of behaviour and culture we also assess whether banks are capable of adapting their organisations to changing market circumstances. Through our change effectiveness examinations we have learned that a lack of visible leadership and the inability to make employees actively participate in transformation efforts are reasons for banks having difficulty in implementing change effectively.

Between 2015 and 2017 several pilots were successfully undertaken to test the added value of our board and change effectiveness approaches for European banking supervision. Behaviour and culture supervision frameworks have been adopted by the Supervisory Board, and several examinations have been held at significant banks across Europe. Five of these examinations took place in Ireland, with DNB and the Central Bank of Ireland (CBI) working together. Since then the CBI has also decided to allocate resources for the supervision of behaviour and culture.

Our experience is that identifying the behavioural root causes of persisting supervisory problems adds value to prudential supervision. Knowing the “why” of these problems increases the supervisor’s knowledge and understanding of the bank and creates opportunities for intervention to solve them.

European banking supervision has not yet organised resources to start its own behaviour and culture unit. We hope it will do so in the near future. Until then, DNB’s resources are available to the ECB’s joint supervisory teams.

The Dutch banking sector is relatively competitive and in a fairly healthy state. What are the key ingredients and are there lessons others can learn?

Dutch banks did not exit the global financial crisis unscathed and some are still in a recovery stage. But the crisis taught them a few key lessons, one of which is the importance of being sustainably profitable. The returns on equity (RoEs) attained before the crisis were built on shaky foundations such as excessive risk-taking and leverage. After the crisis, banks realised that they must rely on more robust asset quality and enhanced cost efficiency to improve their bottom line. Dutch banks re-oriented their business models by focusing more on cost control and less risky lending, which, in turn, helped push down their provisions. Similarly, RoEs were less subject to being artificially boosted by increasing leverage.

Banks are now benefiting from this strategy through the relatively low cost of wholesale funding and a more stable return for their shareholders throughout the cycle. The current healthy state of the sector notwithstanding, Dutch banks are still facing headwinds from, for example, the low interest rate environment, legacy IT systems and vulnerabilities to misconduct risks. These must not be overlooked by supervisors.

You joined the Supervisory Board in 2018—so four years after the Single Supervisory Mechanism (SSM) was created. How do you think supervision at European level is working? What do you see as advantages, what as challenges?

I’m very impressed with the achievements of European banking supervision under the SSM. I have seen very high quality supervisory processes appear in a very short time, which is a sign that we’ve definitely moved on from the start-up phase. It’s great to see that we have been able to reap the benefits and learn about different supervisory approaches, some of which we’ve adopted to create a melting pot of best practices. For example, the on-site missions were completely new to DNB but have proved to be both efficient and effective, and to provide valuable insights.

It’s important that we’ve helped avoid tunnel vision and the penchant for biases by broadening our relationship with banks from just the national level to the European level. This contributes to independent assessment and judgement. At the same time, the challenge to keep this European focus remains. It is therefore our ambition to deploy more cross-country on-site missions to keep learning from each other’s experiences.

Now that European banking supervision has entered a more mature phase, we need to retain a forward-looking strategy and develop a long-term vision. Focusing on greening the financial system must be a part of this.