Blog: Why do resolution and deposit guarantee authorities need to care about the green transition?
Resolution and deposit guarantee authorities has been set up to ensure that severe financial problems within the financial system can be dealt with as smoothly as possible while avoiding the use of taxpayer money. Our task is to ensure that any shock internal or external to the banking sector, whatever the cause or the magnitude, does not snowball into a system wide banking crisis too.
During the Covid-19 pandemic the banking sector was able to continue supporting the real economy. Banks were sufficiently well capitalised to manage the increased risks stemming from exposures to sectors greatly affected by the lock downs and travel restrictions. Monetary policy and fiscal measures did naturally also help. Hence, we have not to date seen bank failures related to the pandemic.
In the beginning of March 2022, we saw how European authorities within and outside the banking union acted together to ensure the protection of financial stability, protection of depositors and protection of taxpayer’s money as the Austrian subsidiary of the Russian Sberbank was deemed failing or likely to fail. (ref. 1) The reason for the failure was new and the situation escalated rapidly, but authorities were able to act in a timely manner regardless.
In the future resolution and deposit guarantee authorities across need to be prepared to manage also crisis situations stemming from climate change and the much-needed green transition. As with any shift in the business environment, we need to assess the implication on the institutions in our remit. There are several aspects that we need to account for, but in this blog, I will only mention a few.
The funding needed for investments enabling the green transition is enormous. For example, the European Commission has estimated that 350 billion euro in additional annual investment is needed to reach the 55% reduction target in greenhouse gases by 2030. (2) However, the pace of transition must be faster, and the amount need for investment must be greater, so that we can reduce our dependence on Russian energy. Everyone must pitch in. We need public funds, allocation of resources through capital markets and bank lending.
Shift from deposits to green investments
From a consumer perspective the discussion on the green transition started with transport and choices made in the grocery store. Now we realise that this will affect everything that we do including how we manage our personal finances. We already see an increasing interest in possibilities to invest sustainably though for example funds with high ESG ratings and funds picking companies that has an impact on the climate change through their innovations, products or services. For example, in the EU there was a three-fold increase in the ESG fund assets between mid-2020 and end-2021. (3) This does not necessarily only mean reallocation across securities from brownish to green. Also new money is expected to pour into the investment scene. Yet, we do not see significant decline in the level of deposits as the pandemic resulted in precautionary and forced saving, which has maintained household deposits at a comparatively high level. But in the future, we might well experience a rather dramatic shift in customer behaviour reducing the amount of deposits kept as buffer on a bank account, while increasing the wealth channelled directly to green funds and securities.
This shift is expected to be greater for banks without a convincing climate policy and that continue funding companies that do not take the needed shift to a greener way seriously. Also institutional investors might be less inclined to provide market funding at reasonable prices to such banks. In a worst-case scenario, the implication on the liquidity situation of a bank can be so severe that the bank would no longer be viable. Then a resolution authority would need to take a decision on whether or not to resolve the bank, and a deposit guarantee authority would possibly manage the pay-out of covered deposits in case the bank would be liquidated.
Resources needed to improve reporting and risk management
So that depositors and investors can make informed investment decisions, there is a need for informative, detailed and comparable data. Currently there are numerous initiatives that will improve the situation. In the EU financial market participants are to provide information on the extent the funds they manage promote environmental or social characteristics or are sustainable investments according to the sustainability-related disclosures in the financial services sector (SFRD). Banks are to report the share of the loan portfolio, which is compliant with the climate change mitigation and adaption objectives of the Taxonomy. The related draft Regulatory Technical Standards (RTS) has not yet been approved by the European Commission, but banks are recommended to use them in the meantime. (4) Banks are also to account for ESG related risks in the credit processes in according to EBA guidelines on loan origination and monitoring. Within the banking union, the ECB has outlined supervisory expectations on what banks are to disclose and monitor on climate-related and environmental risks.
The tricky thing is that companies are not yet required to report the information needed for the assessment. The first set of EU sustainability reporting standards as envisaged in the Corporate Sustainability Reporting Directive (CSRD) is expected to be adopted later this year based on the European Financial Reporting Advisory Group (EFRAG). The International Sustainability Standards Board (ISSB) established during COP26 in November 2021, has, based on the work of the Taskforce for Climate-related Financial Disclosures (TCFD), published the first set of global standards for consultation, but it will take some time before the global standards are in place. However, this is not only about lack of data, but also about deficiencies in banks processes. Only 10% of the significant institutions included in an ECB assessment done last year have an approach to identify the data needed to assess climate-related and environmental risks and 90% report that current practices are only partially or not at all aligned with the ECB’s supervisory expectations. (5)
Reporting teams and IT development resources will hence be very busy catching up, possibly leaving less room to develop capabilities to report information needed by resolution and deposit guarantee authorities in case of failure be it data enabling implementation of bail-in or information of deposits enabling a timely pay-out within 7 days. The latter is also needed to make banks resolvable.
New vulnerabilities with implications on asset quality
The important role of banks in the green transition does come with new risks. This has been highlighted by institutions such as the Network for Greening the Financial System (NGFS) and the European Systemic Risk Board (ESRB) . (6) The above-mentioned ECB assessment show that almost all banks that has made a thorough materiality assessment see that climate-related and environmental risks have a material impact on the risk profile in the coming three to five years. Hence, it is not too farfetched that weaknesses in risk management left unattended might result in bank failures sometime in the future.
We as resolution and deposit guarantee authority need to understand where the possible weaknesses are and how physical climate risks, such as implications of droughts and floods, and transitional risks stemming from shift in government policies, technological developments, or investor and consumer sentiment on the road towards a greater use of renewable resources possibly affect the value of bank assets. (7) This is particularly important as we are to establish the magnitude of losses in case a bank has been deemed failing or likely to fail. Based on this information the depth of bail-in is determined. This information does also feed into a possible decision to separate good assets to be sold from the ones related for example to stranded assets that need to be transferred to a bad bank and wound down.
To sum up: Deposit insurance and resolution authorities need to care and have the means to react as needed
These are some of the aspects why we as resolution and deposit guarantee authorities need to care about the green transition. They relate to liquidity, reputational and credit risks – through a number of different channels - as well as banks’ ability to provide data in a timely manner, themes we continuously address and for which we have tools in case risks realise. Hence, we do not need to redo the crisis management and deposit insurance framework to be able to manage a crisis stemming from the climate change or green transition.
Rather we need to continue the work to strengthen the framework so that it is useful in any situation. We need to finalise the banking union with EDIS, we need to make better use of the transfer tools, we need to ensure access for liquidity in resolution, and we need to improve the readiness of authorities by bringing them even closer, even having the resolution and deposit guarantee authority under the same roof, the benefits of which we see every day. (8) Also, while echoing the views of the SRB Chair Elke König (9), it is important that we do not bargain with bank regulation ensuring financial stability be it capital requirements that reflect the true risk of a green or brown loan, MREL targets or contributions to the SRF and the deposit guarantee fund. These and other requirements need to be in place to enable us authorities to act in case needed. As the banks are resolvable and bail-out with tax-payers money is avoided, public funds can be channelled to important investments such as facilitating the green transition.
Hanna Westman
Chief Economist
References:
1. SRB press release 1.3.2022, SRB adopts resolution decisions for Slovenian and Croatian subsidiaries, decides no resolution action required for parent company in Austria.
2. European Commission, State of the Union: Questions and answers to the 2030 climate target plan, 17.9.2020.
3. The European Supervisory Authorities (ESAs) Joint Committee Report on risks and vulnerabilities in the EU financial system, March 2022.
4. EBA press release 25.3.2022, ESAs issue updated supervisory statement on the application of the Sustainable Finance Disclosure Regulation.
5. ECB, The state of climate and environmental risk management in the banking sector, November 2021.
6. NGFS, A call for action Climate change as a source of financial risk, April 2019; ESRB, Climate-related risk and financial stability, July 2021.
7. BCBS, Climate-related risk drivers and their transmission channels, April 2021
8. SRB blog by General Director Tuija Taos 28 October 2021, Why not have one, neutral and integrated safety net system for resolution and deposit guarantee?
9. SRB Chair, Elke König's speech at the ECON Committee 1.12.2021.
