Economy

Role of Central Banks and financial systems

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“For peace to reign on Earth, humans must evolve into new beings who have learned to see the whole first”, said Kant. 

Climate change is real; it affects and will affect everyone. Mother Nature sends its signals regularly, and most recently through the flash floods in western Germany. These signals are an urgent reminder that we need to take action now. The action must be collective, significant, timely, and futuristic because, in the long term, the risks outweigh the costs. 

The Paris climate accord is one such step in the right direction. A holistic and stakeholder-driven approach would be required to achieve the target of maintaining temperature rise by 1.5 degrees Celsius. One of the most significant stakeholders in such efforts is the global financial system. The financial system’s role is pivotal because they provide finance and steer economic growth. Their actions have a significant impact on ESG, i.e., Environment, Society, and Governance.

There is a tremendous surge in investments which keeps ESG at the core of investment decisions. According to Bloomberg, ‘ESG assets may hit $53 trillion by 2025, a third of global AUM’. Despite a phenomenal rise in ESG assets in the past decade, the financial system still faces challenges like ‘short-termism’ and ‘greenwashing.’ 

Therefore, the role of Central Banks is vital. They look at the financial system of a country as a whole. Former Governor of the Bank of England, Mark Carney coined the concept ‘Tragedy of the Horizon’ to explain this. He argued, “the catastrophic impacts of climate change will be felt beyond the traditional horizons of most banks, investors and financial policymakers, imposing costs on future generations that the current one has no direct incentives to fix.” It is a tricky paradox where the current system has little or no benefits but to save the planet in its current state or better for the coming generations.

Realizing the importance of its role, eight central banks and supervisors created (In December 2017) a ‘Network of Central Banks and Supervisors for Greening the Financial System  (NGFS).’The NGFS is aimed to make coordinated efforts to combat climate change. As of June 30, 2021, the NGFS has grown to a network of 95 members and 15 observers. The Network’s purpose, in their own words; “to help strengthen the global response required to meet the Paris agreement’s goals and enhance the role of the financial system to manage risks and mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development.” 

The NGFS is a significant step towards bringing central banks of different countries together and ensuring that central banks take the leadership role in fighting against the climate crisis. In its first comprehensive report (Pub 2019), It came up with the following six suggestions and floated the idea of global collective leadership. 

1. Integrating climate-related risks into financial stability monitoring and micro-supervision 

2. Integrating sustainability factors into own-portfolio management 

3. Bridging the data gaps 

4. Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing 

5. Achieving robust and internationally consistent climate and environment-related disclosure 

6. Supporting the development of a taxonomy of economic activities

Additionally, the steps taken by the Central Banks of England (Bank of England) and France (Banque de France) are noteworthy and worth a mention.

Recently, the [Central] Bank of England launched a stress test for banks and insurers to understand the ability of the UK Financial system to cope with climate change. The test is aimed to examine the resilience of the UK’s 19 biggest banks and insurers. The stress test can also be looked at as an acknowledgment that Climate Change poses significant financial risks to the existing financial system. Therefore, early planning of a transition is necessary. 

Moreover, ‘Banque de France,’ the central bank of France, took several initiatives to transition the financial industry into zero carbon.  In June 2021, the French ACPR (Autorité de contrôle prudentiel et de résolution, English translation: French Prudential Supervision and Resolution Authority) published the first climate pilot exercise report an overall ‘moderate’ exposure to climate risks.

Let’s understand the risk through an example. Investing in fossil fuels may generate returns in the short term,’ but it will accelerate climate change and, hence, negatively impact the ESG. The negative impact on climate could cause erratic rains or severe drought, leading to an adverse effect on investments made in agriculture and allied sectors. One sector’s gain can be the loss of another sector, posing a significant risk before the overall financial system. 

To ensure a smooth transition of the financial system towards sustainability and make it resilient from other systemic risks, early and coordinated action is needed. Central Banks and financial systems have a significant role to play in our journey towards sustainability.

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Disclaimer

Views expressed above are the author’s own.



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