Banking and finance in stressed times: the greening of central banks’ mandate
By David Ramos Muñoz
No matter how much the financial sector has changed in recent years to accommodate climate change and sustainability, when things get complicated, heads turn towards central banks. They have always been figures of authority in the economy and financial markets, even more so after the 2008 Great Financial Crisis (GFC). Yet, the role of central banks vis–à–vis climate change remains controversial. Is it a mutation of mandates, or an adaptation to new information?
Rosa Lastra, Sir John Lubbock Chair in Banking Law, provided an excellent overview of how central banks have evolved through history, and in recent years. She spoke of ‘mandate’ in a broader sense, which comprised the mandate itself, as well as objectives and tools.
In light of this, central banks’ role has evolved for decades (and, in some cases, centuries) while the idea of an independent central banks primarily focused in the pursuit of price stability is more recent. The GFC already made apparent the need to extend the mandate (if legally possible) to financial stability. Climate change is a new challenge for central banks. This expansion of objectives and functions raises risks for independence and credibility and suggest that we need to devise commensurate measures of accountability to match the extended powers.
These challenges notwithstanding, we need to be creative about how best to incorporate climate or sustainability aspects into central banking and what the best distribution between political authorities and depoliticized agencies with narrower mandates is. This requires a more granular approach, which looks at the specific objectives, functions and tools that central banks have at their disposal.
Some central banks have ‘secondary’ objectives (ECB) or means to liaise with the government (Bank of England remit letters). As to the tools, monetary policy relies on blunt tools or instruments (conventional interest rate movements in particular) that are best destined to control inflation. The use of selective QE green programmes and collateral policies raise the thorny issue of central banks picking winners and losers. Macroprudential tools may be adapted, if new systemic risks are properly defined and measured. Microprudential policies and instruments are best adapted to sustainability considerations, and from supervisory ratings (CAMELS) to stress tests and the role of gatekeepers, progress has been made, though this still requires further of technical work, such as the one undertaken by central banks and supervisors within the Network for the Greening of the Financial System (NGFS).
Beyond that, it is useful to also look at examples of investment practices where ESG and other ethical considerations have been considered for a longer period of time, such as the Norwegian Sovereign Wealth Fund (The Norwegian Government Pension Fund Global). Finally, a ‘broadened mandate’ (or a broadened understanding or interpretation of the mandate) requires a new emphasis on accountability, which comprises legislative and judicial accountability as well as the de facto support by public opinion, which in turn requires improved communication, and a degree of cooperation with the political/fiscal authorities.
Alessandro Gullo, IMF Assistant General Counsel (though the views he expressed where his own, and could not be attributed to the IMF, Executive Board, or its management), complemented Rosa Lastra’s conceptual overview with an analysis of how central banks (and banking supervisors) may approach the integration of climate change policies into their mandate, in practice and in light of best practices.
An initial consideration is that of legal certainty, i.e., although the primary responsibility of fighting climate change rests with governments, the legitimacy of the role of central banks and financial supervisors is based on the principle of attribution, and the clarity of mandates. Thus, rather than a ‘new’ mandate, climate change enters the stage because it has an impact on price stability and financial stability – and particularly when climate change raises risks from a price stability or financial stability. This means that there is no need to amend central banks mandates for them to address climate change, but also that central banks have no active role to promote climate policies beyond this mandate. Moreover, their actions must respect principles such as non-discrimination and proportionality. ‘Secondary’ objectives may also provide a basis, but it is now always clear whether ‘developmental’ mandates encompass the fight against climate change, and in any case this should not be detrimental to price stability or financial stability.
The incorporation of climate change requires paying attention to central bank functions (the “what” they do) as different considerations apply to each of them (monetary policy, for eign reserve management) and it is not advisable to perform certain activities (e.g., quasi -fiscal activities) in light of climate change policies. Decision-making structures should enable a comprehensive and coordinated view over climate policies, to factor in the different perspectives (e.g., monetary policy, financial policy, risk management).
Bank Supervisory Agencies (BSA) for their part, involve their own complexities, because their primary purpose is the safety and soundness of institutions and the financial system. Again, climate change is relevant insofar it raises risks endangering such purpose. One issue relates to the mismatch between the long-term effects of climate change and the shorter time horizon of supervisory policy. This calls for the importance of the precautionary principle, the principle of proportionality, and due process safeguards in the action of BSAs. There is an increasing coverage of climate change in legal instruments. Prudential instruments expect banks to incorporate climate risks in areas such as business model and strategies, governance or risk management. Governments can aid this effort by passing taxonomies, or through interagency coordination, while respecting the autonomy of central banks and BSAs.
Marguerite O’Connell, Senior Counsel from the ECB, completed the picture by explaining how this global perspective is assimilated ‘regionally’ by the ECB, an institution that is at the forefront of the consideration of climate risk.
The ECB made climate change a key aspect of its Strategy Review in 2021, by acknowledging that climate change has profound implications for price stability, and by stating that the Governing Council is committed to ensuring that the Eurosystem fully takes into account the implications of climate change and the carbon transition in central banking.
As to its ‘secondary’ objective, the Governing Council clarified that where two configurations of the instrument set are equally conducive and not prejudicial to price stability – the ECB will choose the configuration that best supports the general economic policies in the Union.
The ECB has taken forward the outcome of the Strategy Review by announcing a number of measures in its Climate Action Plan. First, the ECB decided to engage in ‘tilting’ its ‘market capitalisation benchmark’ for corporate bond holdings towards issuers with better climate performance. Further measures, which are currently under preparation by the ECB, will include limiting the share of assets of entities with a high carbon footprint that can be pledged as collateral, and by requiring compliance with the EU’s new disclosure rules (CSRD) as a condition for the eligibility of certain assets as collateral, along with adjusting its risk assessment tools and capabilities.
As regards the first measure, ECB’s ‘tilting’ policy in respect of its corporate bond holdings has been based on its primary objective and secondary objective, as well as taking int account the Treaty-based principles of integration (Article 11 TFEU) and consistency (Article 7 TFEU). In addition, the measure was carefully designed to ensure compliance with the Treaty principles of proportionality, and of an open market economy with free competition, favouring an efficient allocation of resources.
On the latter point, the ECB has utilised its accountability framework, in the form of exchanges of letters with MEPs, to provide further explanations, in particular on the discussion related to the topic of ‘market neutrality’, and how a departure from the market neutral approach can be justified on the basis of the objectives of the measure, especially (climate) risk, which is not properly priced by the market.
Finally, the presentation focused on some emerging aspects that both central banks and supervisors need to be mindful of, in carrying out their mandates. One such aspects is climate- related litigation, which was specifically signalled by the NGFS in 2021 as an emerging source of risk. Defendants to climate-related litigation include public entities, like governments and central banks, private entities, typically corporates such as carbon-intensive firms, such as energy, transport or construction companies, but also agriculture and food companies, and also, of course, financial institutions. Climate-related litigation can have a cumulative, and, eventually, a systemic effect.