A Safer Transition for Fossil Banking

This report from Finance Watch lays bare the enormous exposure to fossil fuel assets of the world’s biggest banks, and offers a calculation of where capital requirements should be set to capture the financial stability risk associated with these exposures. It also addresses some of the practical implications of such a proposal.

The authors show that the world’s 60 top banks have US$1.35tn of credit exposure to fossil fuels, a figure drawn from a survey of the banks’ annual reports. They point out this is a similar level to bank exposures to subprime mortgages prior to the 2008 financial crisis.

The report reaffirms the argument made by Finance Watch and others that fossil fuel assets should be treated as “higher risk” and assigned a risk weight of 150% in line with the Basel Framework. It refers to previous work arguing that such precautionary risk weights are necessary because backward-looking risk models cannot account for the radically uncertain nature of banks’ climate-related financial risks.

The paper calculates that implementing precautionary risk weights on fossil fuel exposures globally would require an average of US$3.05bn in additional capital per bank. It says this is an amount the banks would easily be able to absorb, equivalent to 2.85% of their current equity or 3.42 months of their 2021 aggregate net income.

The authors argue supervisors should work with banks to achieve the needed capital increase over a carefully judged timeframe. They say this should account for the scale and maturities of fossil fuel exposures, in order to avoid disruptive effects on lending and also reflect banks’ ability to generate capital organically through their profitability.

The paper points out that a much larger capital increase than the one proposed was implemented following the global financial crisis, when banks achieved their targets over 18-24 months without any reduction in lending or total assets by using a combination of retained profits and higher lending spreads.