LSE and The Grantham Research Institute on Climate Change and the Environment are exploring the case of the Bank of England’s prudential regime through its latest release “Preventing a ‘climate Minsky moment’ : environmental financial risks and prudential exposure limits.

It is an increasingly accepted reality that the transition to net-zero affects specific parts of the economy and the profitability of related financed activities. This exposes the financial sector to so-called ‘transition risks’. There is a strong and urgent need to build resilience in the financial sector to identify, assess and mitigate these risks.

A role for financial policy in mitigating the risks from climate change

In examining the potentially significant transition risk present in transition-sensitive sectors, the first aim of this report is to establish a firm basis for central bank supervisory action: central banks and financial supervisors, including the Bank of England, are ultimately responsible for ensuring the financial resilience of individual banks and the financial sector.  

A ‘transition-aligned Large Exposures framework’ for the Bank of England

The report’s second aim is to propose a policy change to adequately identify and mitigate the transition risk, overcoming the inherent challenges. It proposes a ‘transition-aligned Large Exposures framework’ for the Bank of England that would introduce a ‘soft’ limit to individual banks, based on their largest exposures to transition-sensitive sectors.

The Bank of England would map and assess commercial banks’ large exposures to transition-sensitive sectors. A ‘soft limit’ of 25% of eligible capital for aggregate large exposures to relevant economic sectors could be introduced. If breached, banks would be required to undergo a pre-defined climate-related disclosure process. The disclosure is focused on the climate mitigation strategies of underlying (non-financial) companies in banks’ portfolio exposure as well as their risk management and governance processes on climate risk.

Relevance beyond the Bank of England

While the report focuses on the Bank of England because of the Bank’s remit, the challenges it highlights, as well as the proposed policy change, are highly relevant to other central banks and financial supervisors around the world, too.

Summary recommendations

  1. The Bank of England should assess banks’ large exposures to transition-sensitive sectors and explore the climate policy alignment of the underlying counterparties. The Bank of England should conduct an assessment based on banks’ large exposures reporting to measure the size of potential transition risks and create an evidence base to explore further policy action.
  2. The costs of the transition for underlying companies needs to be understood, to assess the policy impact. Underlying companies will incur costs from transitioning, which will vary depending on the sector, and may cause policy-induced transition risk.
  3. The Bank of England should examine the exposure to transition-sensitive sectors in banks’ exposures that are not defined as large. This would explore whether substantial transition risk is present elsewhere in banks’ portfolios and confirm if further prudential action beyond Large Exposure restrictions is needed to mitigate transition risks.

The proposed transition-aligned Large Exposures framework would necessitate several calibration adjustments of the Large Exposures regime:

  • Increase the understanding of climate-related risks to the real economy among sector-specific experts to enable the targeted recalibration of prudential measures.
  • Increase the required granularity of current sectoral reporting within the Large Exposures framework.
  • Ensure there are consequences for inadequate disclosure or risk management of banks’ climate-related large exposures, utilising certain supervisory powers.

The LSE report – Preventing a ‘climate Minsky moment’: environmental financial risks and prudential exposure limits – is available here.

Preventing a ‘climate Minsky moment’

Source: Hugh Miller and Simon Dikau, LSE, The Grantham Research Institute on Climate Change and the Environment

Preventing a ‘climate Minsky moment’

Note: Minsky Moment is named after economist Hyman Minsky and defines the point in time where the sudden decline in market sentiment inevitably leads to a market crash.