Pressure on banks to test ‘natural’ capital adequacy

A shareholder action launched against the Commonwealth Bank for allegedly failing to properly disclose climate change risk in its accounts has turned the spotlight on banks’ need to stress test for climate change risk as well as credit shocks. In the first of a two-part series, Minter Ellison partner Keith Rovers looks at what this means for lenders and investors.

Banks are under attack from all sides. They are subject to a major bank levy, new accountability rules for senior managers, the Federal opposition keeps threatening a Banking Royal Commission, APRA is raising bank capital targets, the ACCC is examining price fixing on inter-bank lending rates and AUSTRAC is now on the war-path because of alleged breach breaches of anti-money laundering and anti-terror financing rules at the Commonwealth Bank.

Then there are competitive pressures, including those arising from technological development and disruption and now the broader global environment with climate change risk impacts on loan and investment portfolios and insurance lines. 

So, whilst post-GFC, national governments and regulators, ratings agencies, and the banks themselves, stress test their balance sheets and loan portfolios to withstand credit shocks, they are also now needing to stress test those loan books, asset management portfolios and insurance lines for the impacts of climate change risk.

This includes discounting for stranded assets as well as the financial impacts of mitigation and adaptation risks on the businesses they lend to, invest in and insure. So, in the same way the big banks run their own models for financial capital adequacy now they will need to test for ‘natural’ capital adequacy. Failure to do so could leave them exposed to legal risk from regulators, disgruntled investors and activists.
 

Highly litigious times

For instance, the G20's Financial Stability Board - whose task force recently issued its disclosure and financial reporting guidelines - has warned that banks can be exposed to climate risk through their borrowers, particularly if they provide loans to fossil fuel producers or agricultural and food companies. The FSB also said banks could also become subject to litigation related to their financing activities.

This week, class actions have been launched by US local governments against global oil and mining companies in relation to infrastructure adaptation costs to deal with rising sea levels caused by climate change, resulting from fossil fuel combustion.

So, we live in highly interesting - and highly litigious - times. Consider the US$35 billion loss suffered from Superstorm Sandy in 2011, the second costliest hurricane in US history after Katrina in 2005. 

It is estimated that a 20 centimetre rise in sea levels at the southern tip of Manhattan Island Increased Superstorm Sandy's surge losses by 30 per cent (up to US$8 billion) in New York alone. Whilst banks might not be at the front line of such claims yet, they are lenders to, investors in and often insurers to such entities.

We recently saw pickets outside Westpac and CBA demanding they rule out the mere possibility of financing the Adani coal mine.
 

Impact investing

If you’re a bancassurance group say with a bank, wealth management arm and insurance business, you could be exposed in each of those business lines without knowing your aggregate exposure because you’re looking at the risk from the perspective of those discrete business lines, rather than a 'whole of organisation' stand point.

But threats also bring opportunities and, whilst there are many issues and external forces occupying the finance sectors boards' minds now, it is not all doom and gloom. There are a number of interesting developments occurring as private finance seeks to tackle climate and social issues at scale. Recent green and social bond issues and the growth of impact investing come to mind. 

Australia is currently at the forefront of green bond issuance accounting for over 30 per cent of bonds issued in Australia for the 2017 first quarter for renewable power projects, green buildings and other energy efficient projects. We have also seen the first asset-backed securitisation of rooftop solar panels. The global green bond market globally is expected to exceed $200 billion by 2018.

While this represents 20 per cent of the climate-aligned funding market and is an even smaller proportion of the US$90 trillion global bond market, there is a clear and impressive growth trajectory and the 2015 Paris Agreement goal of mobilising private finance will only provide more impetus.

In a confluence of the green and social sectors, National Australia Bank recently issued its first social inclusion bond under the Green Bond Principles' Social Bond guidance criteria (with the bond linked to its financings of employers of choice for gender equality). 

These developments are just the start and the market is set to grow exponentially, creating a new asset class and tapping new investor groups, including the growing ethical funds.

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