Thematic Tags: Micro prudential supervision

Inclusive green finance: A new agenda for central banks and financial supervisors

Climate change and environmental degradation can have profound economic impacts, which may translate into micro- and macro-financial risks that need to be addressed by central banks and financial supervisors. Green finance and financial inclusion have mostly been treated by central banks and financial supervisors as two distinct and largely unrelated agendas, despite meaningful overlaps between these two areas. Key target groups for financial inclusion tend to be disproportionately exposed to the impacts of climate change and environmental degradation, while also playing an important role in adapting to and mitigating environmental change.

Against this backdrop, central banks and financial supervisors can combine green finance and financial inclusion policies in an integrated inclusive green finance (IGF) approach. By accounting for equity concerns in the design of green policies, this policy approach can avoid any potential adverse effects on economically vulnerable groups, and enable central banks and financial supervisors to foster a just transition to an environmentally sustainable economy.

Central banks and financial supervisors have various tools at their disposal to translate the concept of IGF into actionable policies. By bringing together the complementary aims of green finance and financial inclusion, they can help to improve the livelihoods of low-income households and the business prospects of micro, small and medium-sized enterprises (MSMEs) while simultaneously contributing to climate change adaptation and mitigation, minimising associated risks for the financial sector.

The instruments that central banks and financial supervisors can use to leverage IGF for climate change adaptation and mitigation can be divided into market-shaping [indirect] policies and direct interventions. A range of IGF policies have already been adopted by the banks and supervisors, and there are emerging examples of best practice.

Integrating sustainability concerns in financial supervision – exploring complementarities across institutional contexts

The Paris Agreement committed the signatory jurisdictions to make financial flows consistent with a net zero future. A variety of new international networks and standard setting bodies are emerging to ensure the development of adequate approaches and methodologies to ‘green finance’ across asset classes (banking, insurance, capital markets). These include the Financial Stability Board’s Task Force for Climate-Related Disclosures (TCFD), the Network for Greening the Financial System (NGFS) and the International Sustainability Standards Board (ISSB). In addition, established bodies such as the International Association of Insurance Supervisors (IAIS) and the Basel Committee for Banking Supervision (BCBS) are also developing frameworks to address risks related to sustainability transition in insurance and banking respectively. Within such globally developing ‘green finance’ frameworks, individual supervisors adopt different approaches, for example regarding the scope of sustainability concerns and regulatory tools used. 

In this context, what remains still understudied are the institutional factors that shape banking supervisors’ individual approaches. The project analyses comparatively how public authorities are using the prudential frameworks to address environmental and social risks across countries and asset classes. The different legal routes (legislative, regulatory, supervisory guidance) to introducing prudential treatment of environmental and social risks are identified for both banking and insurance at national level and juxtaposed with the emerging global standards. Factors considered in the comparative analysis include the scope of mandate, the institutional set-up (e.g. whether the supervisor is a central bank or another authority), independence and accountability mechanisms. Case studies are drawn from the supervisory practices of the ‘leaders’ of sustainable finance trend in the European Union (Banking Union, Hungary, Sweden) and beyond (Brazil, United Kingdom and China). 

The project contributes to filling three gaps in sustainable finance and related regulation and governance literatures. First, it explores the institutional design aspect of ‘greening’ prudential supervision that for now has been neglected in the scholarship on sustainable financial supervision. The ‘institutional fit’ between supervisory architectures and specific regulatory and supervisory solutions in relation to environmental and social risks (‘institutional complementarity’) is identified. Second, the project identifies the ‘balancing acts’ of supervisors in developed and developing jurisdictions with regard to risk- and non-risk aim, showing the different approaches to addressing possible policy objective trade-offs. Third, the project explores the policy layering process that takes place with regard to national practices and international standards in the field of sustainability risk integration.  

Central bank supervisory role: micro-prudential supervision and regulation of ESG risks

Recent years have seen great strides in the deepening of our understanding of how sustainability factors – in particular those related to environment, society and governance (ESG) – may act as drivers of financial risks, and therefore are of relevance to institutions responsible for oversight of the financial sector. This chapter reviews these arguments in the context of the progressive inclusion of sustainability factors in microprudential regulation of the banking sector. New rules at international (Basel Committee for Banking Supervision, Network for Greening the Financial System), regional (European Union) and individual jurisdiction levels require that banks include ESG considerations in their governance. How such rules are implemented on the ground is contingent on the regulatory oversight architecture, that is how the responsibility for different objectives and financial sectors is repartitioned between different public authorities as well as the broader institutional framework the latter operate in. The chapter analyses from this perspective practices of microprudential supervisors in the EU (European Banking Union, Hungary, Sweden) and beyond (Brazil, United Kingdom) that are seen to be leaders in the trend, with view to distil the institutional factors shaping the ‘greening’ of supervision with regard to scope of prudential sustainability concerns and the instruments used. Four out of the five studied jurisdictions have delegated banking supervision to the central bank, which is interesting not least given the significant heterogeneity of financial supervision models globally. The chapter concludes with a discussion of the implications of the comparative analysis with regard to legitimacy (e.g. market overreach) and institutional implications (e.g. need for developed for accountability, institutional design) of micro-prudential supervision and regulation, in particular with regard to central banks.

Sustainable management of central banks’ foreign exchange (FX) reserves

Central banks are playing an increasingly active role in promoting the move towards a sustainable global economy. One key motivation is the need to mobilise funds for the large-scale public sector investment required to reach the goals of the Paris Agreement on climate change. This paper explores the role central banks’ foreign exchange (FX) reserves portfolios can play in this context. Central banks’ frameworks for managing FX reserves have traditionally balanced a triad of objectives: liquidity, safety and return. Incorporating sustainability requires expanding this usual triad into a tetrad. This can be achieved either explicitly, by introducing new economic uses of reserves, or implicitly, by recognising the ways in which sustainability affects existing policy objectives – or through a combination of both approaches. Pursuing sustainability, however, may give rise to trade-offs over and above the usual tensions between liquidity and safety and return. This paper explores sustainability-enhanced reserve management in the context of these trade-offs and outlines 12 different channels (classified into four different types) that reserve managers can use to ‘green’ their operations. Each of these channels comes with its own advantages and limitations, so – given the constraints faced at the individual reserve manager’s level – choosing the right channels is key

Sustainable and responsible management of central banks’ pension and own portfolios

Central banks are increasingly looking to align their operations with sustainability objectives within the constraints of their mandates. This agenda mainly originated in central banks within the broader remit of financial stability, in their capacity as supervisors. However, some central banks have also begun to explore and act on the sustainability implications for their identity as managers of investment portfolios, including sustainable and responsible investment of their pension and own portfolios. The drivers for doing so range from managing sustainability-related risks to aligning their activities with wider government policies and commitments, including with net-zero emissions targets. This challenges the conventional approach that calls for investments to be guided by the trinity of objectives of ‘liquidity, safety and return’, which overlooks the value of an environmental, social and governance (ESG) approach as a means to identify risks and opportunities.

Yet central banks’ progress on this agenda to date has been relatively muted compared with their peers from the wider public investor community such as pension funds and sovereign wealth funds. Only a few central banks are signatories to the UN-supported Principles for Responsible Investment, have climate-related targets, or have made their responsible investment principles public. Low rates of adoption may be due to challenges relating to the availability of data, information and resources, to the particular characteristics of a typical central bank portfolio, or to issues of institutional independence and mandates.

Central banks can learn from their peers from the central banking community that are more advanced in this process, as well as from the wider public investor community in implementing sustainable and responsible investment through strategies including active ownership, ESG integration, impact investing, screening and thematic investing. This paper identifies a recommended course of action for central banks in sequence across the different phases from developing and implementing relevant policy, to monitoring and reporting outcomes, to identifying further adjustments to the policy and its implementation.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

The Effects of Mandatory ESG Disclosure around the World

10 December: We examine the effects of mandatory ESG disclosure around the world using a novel dataset. Mandatory ESG disclosure increases the availability and quality of ESG reporting, especially among firms with low ESG performance. Mandatory ESG reporting helps to improve a firm’s financial information environment: analysts’ earnings forecasts become more accurate and less dispersed after ESG disclosure becomes mandatory. On the real side, negative ESG incidents become less likely, and stock price crash risk declines after mandatory ESG disclosure is enacted. These findings suggest that mandatory ESG disclosure has beneficial informational and real effects.

Working Group on Banking Supervision and Sustainable Development in the Americas

Banking regulations are known to have substantial leverage on the real economy for the simple reason that finance permeates everywhere. By the same token, they are a suitable instrument for improving the preparedness of the real economy for climate change. We convene a working group of prominent practitioners from among the collectivity of bank supervisors and regulators in the Americas, along with recognised experts in the field in order to review the state of practice regarding the incorporation of climate change into micro prudential regulatory frameworks.

For purposes of ordering the discussion, existing and potential practices will be grouped into four categories:

  • Those where the authorities provide finance by instruction.
  • Those where the authorities provide incentives for desired types of finance.
  • Those where the authorities reduce financial risk by socialising potential losses by means of insurance, direct payments, or exceptional access to citizens’ own assets.
  • Those where systems are set up to prevent, contain, and abate negative externalities.

To assist the working group’s deliberations, we will provide reference documents on existing practices, as well as on plausible modifications in existing regulations that can have important positive impacts for climate change and adaptation. The working group will also be asked to discuss the feasibility of specific innovations for making regulations more climate-friendly, and to review potential obstacles, barriers, and resistance to the implementation of such potential change. The document emerging from the working group’s deliberations will provide policy recommendations and, where appropriate, a further research agenda.

Working Group members:

Management of Climate Risks in the Financial Industry of a Resource Based Economy: A Canadian Scenario Analysis

Although some studies exist on how the financial industry is affected by climate risks and how it might manage them, no such studies exist for a country with an economy that is mainly based on carbon-intensive resources, such as oil, gas, and mining. We conduct a scenario analysis based on an impact matrix that uses both physical and transition risks to model impacts on the financial portfolio of Canadian chartered banks. We will complement findings about climate-related risks and opportunities in Europe, Asia, and Africa that are different from climate change-related risks to North America and that are in countries with different regulatory frameworks.

Our research will be based on a formative scenario analysis and an impact matrix will be created based on the Intergovernmental Panel on Climate Change climate scenarios and climate scenarios for Canada. Based on different data sources, we will conduct a MICMAC analysis (a system of multiplication of matrices applied to the impact matrix) to calculate both direct and indirect impacts on Canadian banks’ financial risks. The expected results will help policymakers in countries with carbon-intensive economies to create financial policies, regulations, and supervision regimes that could be applied by central banks and other financial regulators to mitigate climate risk for the financial industry without creating otherwise significant negative impacts for these countries’ economies.

The results of this INSPIRE research will help banks to implement strategies to reduce their exposure to climate-related financial risks. Consequently, negative impacts on the Canadian financial industry could be avoided. This is important given that the Canadian banking sector is dominated by five chartered banks that are similar with regard to their businesses.