European banks are beginning to drop clients that pose a climate risk rather than face the possibility of higher capital requirements, according to the watchdog overseeing the development.
Banks are raising prices, denying loan requests, “de-selecting industries and in some cases clients,” said Jacob Gyntelberg, director of the economic and risk analysis department at the European Banking Authority.
There’s already evidence that upstream oil and gas projects are falling out of favor as banks move beyond coal exclusions. That’s amid growing pressure on the finance industry from regulators and investors to shift over to low-carbon intensity sectors. At the same time, sectors judged to be at the receiving end of climate change — including some corners of the mortgage market — are also being reassessed by banks, the EBA said.
Once viewed as a measure of last resort, the deleveraging comes as the financial sector faces historic requirements to address environmental risks. European lawmakers want to redirect the flow of capital away from industries that pollute, amid unequivocal signs that climate change is already proving deadly and as scientists warn that time is running out.
In a report on Monday, Moody’s Investors Service warned that banks’ loan losses could soar 20% under the most extreme climate scenario. “Climate risk is likely to have a major influence on banks’ loan quality, and depending on how climate change unfolds, and on the policy response to it, the losses that ensue could be substantial,” Moody’s said.
In the lead-up to the COP26 climate talks in Glasgow next month, banks are expected to provide more ambitious statements on cutting their CO2 footprints in updated net-zero carbon emissions goals.
Banks have so far been too slow to address the risks, the European Central Bank said recently. A separate report in May to the European Commission found that while most lenders are trying to figure out how to measure the financial risk of environmental, social and governance factors, few have gotten very far. And while the focus for now is on climate, work on regulating the other two elements in ESG investing is progressing.
The EBA is working with national supervisors and the industry. There’s a fundamental shift under way in how banks do business, and Gyntelberg said his agency is seeing some “encouraging” signs.
Banks are also “making more clear distinctions across the auto loan book, they are making more clear distinctions in the leasing books, they are making more clear distinctions in mortgages,” Gyntelberg said in an interview. “They are looking at sectoral differentiation when it comes to pricing, and they are even saying no.”
Rising temperatures and the sweeping changes that governments and industries are pursuing to mitigate them, present risks to the financial industry in the form of falling collateral values to bankrupt clients. But loan books are where the industry’s vulnerability to a transition to a carbon-free future may be the greatest.
According to Moody’s Investors Service, loans account for two-thirds of the $22 trillion in exposures that the biggest global banks, asset managers and insurance companies have to carbon-intensive industries with the least certain futures.
At the same time, banks have to make good on commitments to help achieve the Paris Agreement, amid pressure from investors to do more to hold temperature increases in check.
“I think we need to take into account that there will be ESG-related risks which won’t remain on banks’ balance sheets,” Gyntelberg said.
Banks that use so-called internal models to identify risks and estimate how much capital to hold already can integrate ESG into those systems, but the challenge they face is having the right data to feed into the calculations, according to Lars Overby, head of risk-based metrics at the EBA.
Such models “are based on historical data, and clearly some of these elements aren’t already in the data,” Overby said. “There is probably a need to have a discussion on whether we can incorporate this in the framework already now, which is not an easy debate.”
Investors, analysts and activists will get a better look at what the risks are toward the end of next year, when banks will have to start making public disclosures following templates that the EBA is currently working on.
The authority expects that, in the run-up to the publication of those reports, lenders probably will already begin to hold capital against ESG risks.
Getting rid of risky assets is one way for banks to reduce the need to add capital. The EBA is monitoring the deleveraging on concerns that excluding some client groups from funding could foment its own crisis. As banks drop unwanted clients, that may push the risks they pose into corners of the financial market that are less regulated and harder to supervise.
“An important consideration from a policy perspective is of course where the risk exposure ultimately sits,” Gyntelberg said. “A possible concern is what the overall financial stability implications are if many of the risks end up being held outside the banking system.”