Central banks & market neutrality: Economic stability, climate risks & adapting mandates

Working within the mandate? Economic stability meets climate action in central banking: Climate Bonds policy view

Central banks are mandated to maintain financial stability, an objective which can increasingly be used to drive green financing and illuminate the role of central banks beyond disclosure.

Here’s why:

Central bankers often see little room for action beyond disclosure, given the market neutrality principle. But the structural risk posed by climate change to stability means monetary policy must be leveraged to reduce exposure immediately, particularly as 2020 saw balance sheets swell with crisis response measures. 

Some central bankers insist that market neutrality means they cannot provide preferential credit to green activities or companies. For example, Jens Weidman, President of the Bundesbank recently argued that, "it is not up to us to correct market distortions and political actions or emissions."

This position is not abreast with current times and our climate crisis.

Asset purchase is inherently non-market neutral, given the bias of capital markets to large carbon-intensive companies. Continuing 'market neutrality' increasingly contradicts or is in conflict with national climate policies, and this long-held principle may be on the way out – the ECB is expected to abandon market neutrality in this year’s strategic remit review.

Fossil fuel companies are overrepresented on supposedly market-neutral balance sheets because risk assessments look to past, not future, performance. The NGFS has made clear the need for forward-looking economic models that assess climate risk impact. These show the physical and transition risk of 'brown' assets and lending.

However, action can’t wait till such models are fully developed. Some central banks have recognised this urgency and already made efforts to reduce risk exposure.


Standout examples: Sweden, Hungary & Fiji

In 2019, Sweden’s central bank, the Riksbank decided to incorporate sustainability into risk and investment policy. It announced a risk-based negative screening programme for its SEK500bn forex reserves and excluded bonds from the highly fossil fuel-exposed provinces of Alberta, Canada, Queensland and Western Australia. Forex reserves need to be low risk, so this decision was within the Riksbank’s mandate to maintain stability.

Exclusion based on risk exposure is seen as less political and interventionist than shifting mandates as Weidman comments above, particularly as the exclusion affected only a small part of the bank’s portfolio: 8% of Swedish forex reserves are Australian and Canadian government/muni bonds.

Sweden’s QE programme was also recently expanded to include sovereign and municipal green bonds as part of the COVID-19 response, and corporate bond purchase will require issuers to comply with sustainability standards.

In 2019, the Hungarian central bank, Magyar Nemzeti Bank (MNB), became Europe’s first central bank to treat green lending preferentially by discounting capital requirements against energy-efficient housing loans. This green lending incentive was justified as it reflects the reduced risk in green mortgages because energy-efficient homes are less likely to go into default.

This was developed following the announcement of the bank’s Green Program. Once more, justification centres on financial stability, demonstrating a widening of priorities and perhaps a renewed understanding of economic stability.

In the Pacific, the Reserve Bank of Fiji’s Import Substitution and Export Finance Facility provides low-cost credit for public transportation, agriculture and renewable energy businesses. The green orientation was made to increase self-sufficiency and reduce vulnerability to volatile international oil prices and ensures currency stability.

Central banks can also play a fundamental role in other Small Island Developing States dependent on fossil fuel imports by using similar schemes to reduce exposure to price fluctuations and encourage economic diversification – a likely priority following 2020’s economic toll.


ECB and PBOC due to follow?

Such measures are likely to become more widespread this year and on a larger scale. The ECB appears likely to move away from market neutrality and will consider how to increase monetary policy and balance sheet resilience to climate risk in its coming strategic review. Recently, the PBOC’s Governor, Yi Gang, announced new priorities to improve green finance standards, enhance climate-risk-analysis capacity and provide easier international investor access to China’s green finance market.

The PBOC has already 'appropriately reduced the risk weight of green assets' and given lower levels of economic capital occupation to green credit-related businesses.


Do banks need a mandate change to take action?

Several central banks have already utilised their existing toolkits to incentivise climate action, demonstrating that incorporation of environmental considerations can fall under their objectives of maintaining economic stability – consistent with the European Systemic Risk Board view, a sudden low-carbon transition would lead to financial instability.

Central banks need to develop forward-looking models that differentiate between green and brown assets. But they should not wait for modelling to catch up before re-assessing existing market neutrality precepts.

Instead of focusing on the drawn-out and complicated process of mandate change, perhaps the banks should re-examine how current lending and asset purchases truly impact stability and sustainable growth. Our September 2019 report 'Greening the playing field' outlines a number of policy measures central banks could adopt.


The COVID example- Facing new challenges

Even within mandates focused on market neutrality, some central banks have demonstrated that there is room for climate action. As more and more central banks request the financial institutions under their supervision to perform climate stress tests and evaluate their portfolios, they must use their asset purchase programmes and other tools as they would have their supervisees behave. 

The COVID-19 crisis has also shown central banks’ capacity for further-reaching and innovative action, increasing interest in both how crisis response can be green and how it paves the way for more interventionist action.

As Christine Lagarde notes, central bankers “will have to ask themselves the question as to whether or not we’re not taking excessive risk by simply trusting mechanisms that have not priced in the massive risk that is out there.”


‘Til Next Time,

Climate Bonds.

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