The Basel III framework was developed by the Basel Committee on Banking Supervision to strengthen regulation and risk management of banks after the 2007-2009 global financial crisis. Though the framework has been effective in supporting global financial stability during the Covid-19 pandemic, it is unlikely to be sufficient for climate change.
The Basel framework largely focuses on strengthening liquidity and capital requirements. The framework design is based on historical data, which is not applicable to the increasing severity of climate change. The framework does not adequately provide recommendations on how banks can undermine financial stability and put countries into a negative macrofinancial loop.
Here’s why the Basel framework is inadequate in considering the challenges imposed by climate change:
- Climate change is going to induce a spike in nonperforming loans in key sectors, such as businesses facing disruptions amid floods, droughts and wildfires, and sectors such as logistics, transportation and food;
- Given the deep interconnected nature of the economy, this will in turn lead to nonperforming loans in intermediate input sectors, retail and the housing market as there is outward migration;
- These climate shocks will lead to high inflation, which central banks may tackle by tightening monetary policy. Higher inflation will lead to reduced access to financing across the real economy, further posing economic stability challenges; and
- Bank and nonbank financial institutions may struggle to manage their own profitability on the back of nonperforming loans, stranded assets and fire sales from investment funds that have high exposure to climate-unfriendly portfolios, further reducing asset prices.
So what to do? First, we need to scale up our modelling of the impact of climate change on the future of the financial sector. This process is not homogenous given that each country and region has different risk exposures, different levels of financial buffering, and different central bank capacities to swiftly activate measures.
Second, we need to consider applying bail-in, to ensure banks failing due to climate change and other related consequences do not become the burden of taxpayers. The burden should be taken up by shareholders and creditors as a first port of call. Using the bail-in approach encourages banks and nonbank financial institutions to price in climate risk. This is particularly relevant now — easy financial conditions have led lenders into high-risk borrowing.
Third, we need to increase capital and liquidity buffers beyond those laid out by the Basel framework, to ensure banks can stay afloat after climatic shocks inevitably hit financial institutions. Banks also need to limit procyclicality — they should retain returns during periods of high economic growth and strengthen capital buffers so that they can draw down on them during stressful periods arising from climatic shocks.
Fourth, we need to strengthen competition policy to reduce exposure to firms with high carbon taxes, which also reduce corporate profitability and risk high rates of nonperforming loans. A new analysis shows that in SA a competitive energy market can enable renewable energy to account for 35% of total energy production by 2030.
In comparison, a rigid energy policy would translate to renewable’s share of total energy sitting at a meagre 12% by 2030. While the government has made good progress, there still is much more to be done to level the playing field between Eskom and renewable energy providers. This will reduce inflation, mitigate a tightening of monetary policy and enable banks to keep lending to the real economy.
And fifth, to facilitate a green transition adopting a bifurcated policy approach is important. This involves strengthening support to mining sectors that are required for green energy technology, including palladium, manganese and chromium, while scaling down support to emissions-heavy sectors such as coal. This may sound like a no-brainer, but an intentionally developed and implemented approach is critical to ensure a reduction in stranded assets and nonperforming loans in linkage sectors.
In recent columns I have explored why climate change can drive up inflation on a permanent basis, and why breaking that macrofinancial loop is important. Today I’m sharing why the Basel framework is deficient on financial risks and how the banking/nonbanking sector has a larger obligation to tackle these challenges, if they want to provide some layer of policy stability.
From a personal point of view, if the transition begins destabilising entire economies, I must reconsider my own life plans. My partner and I grapple with the idea of bringing kids into a world where they cannot access credit to undertake the transition to adulthood, like buying a house or starting a business. Central banks need to help pre-emptively address the shortages of the Basel framework, to mitigate the resulting financial instability.
• Dr Baskaran (@gracebaskaran), a development economist, is a bye-fellow in economics at the University of Cambridge.
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