June 21, 2022 – As regulators generate new rules for financial institutions regarding the monitoring, disclosure and mitigation of climate-related risks, a key issue is: should banks be required to increase their capital buffers?
In “Climate Risk and Canadian Banks: Is More Capital Required?” author and C.D. Howe Institute Fellow-in-Residence Glen Hodgson examines this crucial question.
The Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI) recently released scenarios on the implications of climate change and the transition to net-zero greenhouse gas emissions. With this as a backdrop, the author considers Canadian banks’ options for managing climate risk and whether more capital buffers are needed – especially in a country where capital ratios are already well above the regulatory floor.
“While capital buffers are critical in smoothing out negative economic shocks, they raise the cost of funding for banks, which must rely more on capital than debt to fund their risk exposures,” writes Hodgson. “Related costs are then passed on to borrowers, which may reduce demand for credit or affect a bank’s risk appetite. Adding capital to manage climate risk comes at a cost.”
Hodgson makes two recommendations: (i) any consideration of additional capital surcharges should involve Canadian authorities working with international peers through the Basel Committee on Banking Supervision to agree on how best to incorporate climate risks; and (ii) improving climate risk assessment and disclosure is a better alternative, at present, than further capital surcharges.
As for the BoC/OSFI scenarios, Hodgson says they highlight the risks of significant macroeconomic impacts in a commodity-exporting country like Canada, notably the risk of future declines in commodity (i.e., energy) prices and demand due to global climate policy changes, and that delaying climate policy action increases the overall economic impacts and risks to financial stability.
In the meantime, a green wave of regulations to address climate risk is headed for Canadian banks. OSFI is developing an operating framework for federally regulated financial institutions to manage the climate transition and related risk, which will ultimately be anchored to Basel III. “A central issue is what would represent sufficient conditions for managing climate risk under Basel III,” says Hodgson.
Separately, there is now a rapid, if uneven, evolution globally toward adoption of the disclosure guidelines proposed by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), with momentum building toward mandatory adoption. Hodgson writes that in order to implement the TCFD’s recommendations, banks will need to obtain more standardized and detailed information from their clients on the business and projects being financed, and how the business and related climate impacts will evolve over time.
Canadian banks already have multiple layers of capital protection that limit the potential need for exceptional policy intervention and hold capital well in excess of the Basel III Pillar 1 standard of 8 percent of risk-weighted assets, says Hodgson. “The key question with respect to climate risk is whether, at this stage, banks have taken it explicitly into account in their capital plans, and whether additional capital would be beneficial in managing this risk, which interacts with numerous other risks for which capital is required,” explains Hodgson. “The challenge is that measurement of climate risk is in its infancy and there is a fair amount of uncertainty and judgement required to impose prudential requirements. That reality means it is likely premature to consider imposing a uniform climate-risk calculation on all banks.”
For more information contact: Glen Hodgson, Chief Economist at International Financial Consulting Ltd. and Fellow-in-Residence at the C.D. Howe Institute; or Lauren Malyk, Communications Officer, 416-865-1904 Ext. 0247, lmalyk@cdhowe.org
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