Climate-related extreme weather events and declines in asset values in carbon-intensive sectors are significant financial risks for banks. Yet until recently, the topic has largely remained unexplored by deposit insurers and bank resolution authorities, responsible for the financial system safety net.
By impacting banks’ default risk, climate-related and environmental risks can require deposit insurers to require higher premiums and bigger funds. Moreover, the risk of stranded assets—assets such as fossil fuel holdings which lose value as policies become more stringent over climate change—may rise.
These changes in asset prices may lower recovery rates upon resolution of failing institutions, posing challenges to a deposit insurer’s long-term financial sustainability and to a resolution authority’s strategy.
While more comprehensive guidance may be developed by standard-setters in the future, existing international guidance—namely the IADI Core Principles on Effective Deposit Insurance Systems and the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions— provide a framework in which deposit insurers and bank resolution authorities could take initial steps to achieve climate resilient financial safety nets.
The time to act is now. Deposit insurers and resolution authorities should consider responses to climate-related and environmental risks in the following areas:
Risk monitoring. Deposit insurers should embed climate-related and environmental risks in their early warning systems and risk assessment frameworks. Through appropriate capacity building and coordination with other relevant fora, the effectiveness of early detection and timely intervention would be strengthened by incorporating climate-related and environmental risks.
Risk-based premiums. Where deposit insurers calculate premiums based on risk, the premium calculations could take climate-related and environmental risks into consideration, so that banks whose business models entail higher risks could be required to pay higher premiums. For example, authorities could consider whether banks highly exposed to transition-sensitive industries or to geographical areas more prone to natural disasters—which could lead to a higher risk of bank failure—should contribute relatively more to the deposit insurance fund.
Ex ante funding. On the surface, it might seem unwarranted to explicitly incorporate climate change into deposit insurers’ mandates. However, climate-related and environmental risks could be incorporated into the models used by the deposit insurers to assess their ex-ante funding needs—the target fund ratio—and the liquidity profile of their reserves.
Investment and management of funds. While deposit insurers’ and resolution authorities’ investment policies should always prioritize safety and liquidity over returns, climate-related and environmental risks related to the investment portfolio could be integrated into the investment decision-making process.
Operations. To instill confidence in the market, a deposit insurer should be able to reimburse most depositors within seven working days after a bank failure. Physical risks such as storms, wildfires and flooding can be particularly detrimental to a deposit insurer’s ability to comply with such a timeframe. Therefore, deposit insurers could consider those risks when evaluating preparedness and conducting payout simulation exercises. When hiring paying agents to assist in payouts, the deposit insurer could also consider their ability to deal with climate-related and environmental risks.
Resolution of troubled banks. Resolution authorities could require that banks consider climate-related and environmental risks in the stress scenarios used when preparing their recovery plans. These risks are also important inputs in the development of resolution plans and resolution strategies, as they may affect the likelihood of failure and may limit the response measures available to the authority. Accordingly, resolution authorities could also identify any actions in the recovery plan which may adversely impact resolvability.
In line with its Climate Change Action Plan for 2021-2025, the World Bank stands ready to support deposit insurers and resolution authorities in client countries to better understand climate risks and to consider the appropriate framework for integrating climate-related and environmental risks in their operations.
Pierre-Laurent Chatain and Martijn Regelink contributed to this blog.
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