Silicon Valley Bank crisis shows climate risk can push banks over the brink

As the autopsies come in for the rapid collapse of Silicon Valley Bank (SVB), there is ample blame to go around. One of the main culprits is the same regulator that engineered the extraordinary intervention to calm markets in the wake of the collapse: the Federal Reserve.

As it reviews the many ways its actions failed to prevent or even fuelled this crisis, the central bank should look out for other sources of risk for banks of all sizes with a business model concentrated on a single geography or industry.

As climate change worsens and the energy transition intended to address it accelerates, many of the features of Silicon Valley Bank’s collapse will be increasingly present for banks reliant on high-emitting clients or invested in climate-impacted assets. The Fed should take its SVB review as an opportunity to chart a course around these landmines, instead of letting the economy step on them before it acts. The parallels with climate risk require its attention.

As the tech industry’s favorite bank, SVB grew quickly as startups and venture capital firms parked large cash deposits on its books, in amounts that far exceeded the legal $250,000 limit for insured deposits. Similarly rapid growth has been experienced by a few other banks from an influx of risky oil and gas business.

Faced with a torrent of deposits and little customer demand for corporate loans, SVB tried keeping its profits up by investing in long-term government bonds. Unfortunately, rapidly rising interest rates drove down the prices of these bonds. Accounting rules allowed SVB to avoid recognising these losses as long as it did not sell those bonds. Similarly, banks invested in climate-impacted areas may be able to avoid recognising the effect of unpriced climate risk on their portfolios.

Tech companies, burning cash as rising interest rates hurt their business, started withdrawing their deposits. To cash them out, SVB had to sell some of its bonds and mark the prices of the rest to their depressed market value. The announcement of losses triggered a run, eventually forcing regulators to shut down the bank and intervene in markets to head off systemic risks.

The Fed should see the potential for a reprise of this story driven by climate risk. Oil and gas companies pulling their deposits from favored banks as their economics worsen can trigger the sale of securities whose market price has suffered due to unpriced climate risks. The subsequent realised losses could then accelerate a panic among other depositors.

The boom-bust cycles of oil and gas companies have threatened bank solvency in the past. In 2020, West Texas Intermediate crude oil prices fell to negative levels, raising concerns about the safety of banks with exposure to the sector. Crashes may only become more severe and more frequent as the transition to low-cost, zero-carbon energy accelerates, triggering periodic and persistent crashes in the Permian or North Dakota which are worse than the one in Silicon Valley.

SVB’s troubles were amplified by unrealised interest risks that the Fed’s own stress test scenarios did not anticipate. Risks from climate change and the energy transition are also mispriced and excluded from stress testing. As markets take climate change more seriously, the prices of bonds that are newly understood to be risky may tumble from their face value. Similarly, when banks make loans that are directly related to the operation of oil and gas assets, their value is vulnerable to a rapid transition that increases the chances of the underlying assets becoming uneconomical to operate.

This is just one story and there are other ways, both predictable and unanticipated, that climate risks can cause banks to fail. There are lessons the Fed should learn from this banking crisis that can help blunt the impact of the next one.

First, the Fed’s light touch approach to “smaller” banks must change. SVB avoided classification as systemically important, freeing it from requirements laid on those banks. But its end – coupled with similar collapses at two other mid-sized tech and crypto-related banks, Silvergate and Signature – shows that systemic risk does not come only from systemically important banks. The collapse of any bank can trigger systemic panic if it reveals a bigger problem.

For climate risk, this means changing the current “biggest banks first” approach. The Fed’s pilot climate scenario analysis only covers the risk management practices of six of the largest US banks. At its current pace, a more comprehensive set of reviews may be years away. But as New York’s Department of Financial Services has accurately noted, smaller banks are often most vulnerable to climate risk due to greater geographic and sectoral concentration.

Second, the Fed will need to reverse its Trump-era deregulatory decisions made by the previous administration. Treating SVB with a lighter touch was a policy choice to deviate from the Fed’s global financial stability commitments.

The standard setter for those commitments – the Basel Committee on Banking Supervision – has published guidance on how the framework applies to climate risk management. Importantly, it counsels that banks should be accounting for climate risk in the amount of capital they hold, and using a margin of conservatism in estimating the climate-related losses they might suffer, along with the chances of those losses. The Fed should implement these recommendations as part of its broader review of where it could be more in line with global best practices.

Finally, the Fed must shift how it thinks about its financial stability mandate. For the last few years, it has lurched from crisis to crisis, employing emergency powers to fill gaps. Each step was justifiable in the moment, but created the conditions for the next intervention.

The pandemic rescue helped save over-leveraged, under-regulated hedge funds, the potential failure of which threatened the financial system. Extremely cheap money created speculative bubbles, inflating the tech and crypto industries. Raising rates to combat the subsequent inflation burst those bubbles, taking three banks with it. The latest emergency interventions have explicitly guaranteed uninsured deposits, and let banks who failed to manage interest rate risks off the hook. These moves have raised concerns about the new risk-taking they might enable.

The Fed’s approach to climate risk reflects this same mindset. Even as it signs on to reports that call climate change a threat to financial stability, the central bank’s leadership says that it’s early days in addressing climate risk and hides behind its narrow mandate.

But as disasters like Hurricane Ian and policy shifts like the Inflation Reduction Act show, there’s nothing early about either climate change or the global response. The Fed has not yet published the guidance it needs to formally look at how banks are addressing this risk, much less taken any steps to increase the resilience of the financial system.

The collapse of SVB may not even be the end of the current crisis cycle. But it should serve as a belated wake-up call to the Fed to broaden its view of the risks that banks face, and to redouble its effort in addressing them. That means treating climate risk as a major threat to the financial system, not a box-checking exercise to placate a few voices.