In his keynote speech, Klaas Knot outlines how the issue of ‘sustainability’ got on the DNB agenda, highlighting how and why sustainability is relevant for central banks, supervisors and the financial industry. Secondly, he gives an overview of the climate-risks in the Dutch financial sector. Third and finally, he sketches what this means for bank risk management and supervision.
I. Mission: Sustainability on the agenda of DNB
(…) Our economies had seen too much credit growth, which was not adequately backed up by underlying strong economic and financial fundamentals of companies, households and even of governments. All of these developments were in the back of our mind when we had to come up with that new mission statement for DNB.
One obvious implication of all of this being at the back of our mind, was that safeguarding financial stability was to be a crucial part of this mission. Another implication was that we wanted to incorporate an element of the general good of the societies we serve, contributing to increases in living standards and prosperity of those we serve.
But there was something more, relating to all those crisis developments I just mentioned. Hadn’t the crisis taught us that the prosperity we had created in the years before the financial crisis, had proven to not be durable in the long run? Put differently, the prosperity had turned out to not be sustainable. Because that’s what sustainable means: durable in the long run.
And so, as we were walking down a foggy beach in Zandvoort, trying to come up with this new mission statement, we fortunately had the clarity of mind to add the word ‘sustainable’ before the word ‘prosperity’. Our mission as central bank and supervisors became “to safeguard financial stability and thus contribute to sustainable prosperity in the Netherlands.”
(…)
II. Risks: a thematic review of climate risks in the Dutch financial sector
Which brings me to the second part of this speech. What are the risks that we see as a supervisor in the Dutch financial sector? In 2017 we conducted a thematic review on this issue.
In this review we took a deep dive into four topics:
- climate-related damages for the insurance industry
- risks for the financial sector from a potential flood
- risks from the financing of carbon intensive assets, so called ‘brown finance’
- risks from the financing of assets and projects that are meant to contribute to the energy transition, so called ‘green finance’.
(…) For our research, however we had to develop our own template for our financial sector to fill out. We sent this template to the three biggest banks, covering around 70-80% of the market. What we found is that banks’ balance sheet consist of around 11% of exposures to carbon intensive industries.
Not surprisingly, most of these exposures are through loans, which makes banks less sensitive to market fluctuations than for example pension funds. Moreover, most of these loans have maturities of less than five years, which should provide banks with sufficient scope to anticipate changes. Especially if the transition is more gradual in nature.
In one area however, we already see transition risks materializing, and that’s in the real estate sector. The real estate sector plays an important role in carbon emissions and is therefore sensitive to the energy transition. In the EU, many, if not all, residential and commercial real estate have energy efficiency labels, ranging from A to G, with G being the least energy efficient building. The Dutch government has announced legislation that requires almost all offices in the Netherlands to have a minimum energy efficiency label of C by 2023. Any office that doesn’t meet that requirement can no longer be used.
This affects banks in two ways. First, through loans to regular corporations, who use their own offices as collateral for their bank loans, and second, through loans to commercial real estate companies that lease offices as a business model. If some of these offices may no longer be used, or will need to be upgraded to meet the requirement, this could affect the value of the collateral or the ability of commercial real estate companies to pay back their loans.
So how big of an issue is this for our banks? Unfortunately, neither we nor our banks know the energy label distribution of the offices used as collateral for loans to regular corporations. For loans to commercial real estate companies, banks know of roughly 50% of those loans what the energy label distribution is. Of those loans where we did know the label distribution, we found that 46% of bank loans to commercial real estate companies in relation to offices, have an energy label lower than C. This is around 6bn worth of loans. All these loans, one could say, have elevated credit risks, which banks, one way or the other, will need to manage. Fortunately, we are seeing many banks react swiftly.
Banks are now demanding that any new loan or refinancing of existing loans in relation to those offices is dependent on the client meeting the energy-label requirement on time. This should ensure that banks will have limited exposures to offices that won’t meet the deadline on time. For us, this national legislation is a prime example of how the energy transition will lead to risks in the financial sector.
We also looked at the risks of green finance, as I mentioned. First there is the risk of a green bubble. History shows us that many transitions are accompanied by a boom bust cycle, whether it’s the dot-com bubble in the early 2000s, or the railway mania of the late 1900s. Whenever there’s increasing demand, a hype, or new market opportunities and instruments, there’s the risk of creating a new bubble. While we are still far away from a green bubble, institutions do tell us that green projects have become more and more expensive, as competition has increased with more and more institutions essentially bidding for the same projects. (…)
III. Supervision: Implications for bank risk management and supervision
So let me end with what this all means for bank risk management and supervision. The main conclusion is that banks, including those present today, will need to manage material climate-related risks. And that supervisors will need to supervise this. This is of course easier said than done. If anyone in this room already knows how to exactly manage climate-related risks, please join us at the podium in a minute!
Two things are important to keep in mind here. One: incorporating climate risks is greatly facilitated when governments impose clear and long term transition legislation, which gives banks the ability to steer towards a set of well-defined goals. This is exactly what we are seeing with the energy efficiency requirements of Dutch offices.
(…)
Fortunately we are seeing many financial institutions in the Netherlands and abroad experimenting with incorporating climate risk management. One Dutch bank for example, has incorporated the energy transition into its credit policies for loans to the utility industry. This bank will only finance utilities that have carbon reduction strategies, and the bank wants the average energy mix of the utility companies it finances, to be in line with the 2 degree scenarios from the International Energy Agency.
(…)
This is a summary of the speech by Klaas Knot, President of De Nederlandsche Bank. You can read the full version on the website of the DNB.
Source: https://www.dnb.nl/
