Going Green: Analysing RBI’s Intention to Conduct Climate Stress Tests
-Ujjwal Agrawal
Introduction
Given the huge implications of environmental-related factors on an economy and its wide acceptance in today’s times, there has never been a more compelling case for bringing climate change into account when making macroeconomic modelling and investment and banking decisions. Having said this, it has also been widely recognized now that the central banks have tremendous roles to play in dealing with climate-induced risks through their various mechanisms such as incorporating climate and environmental concerns methodically into their actions, including monetary policy and banking supervision responsibilities, the management of non-monetary policy-related balance sheet, and performance of operational tasks.
In light of this, an attempt is being made on the part of RBI to join major central banks like the European Central Bank (“ECB”) towards incorporating processes that deal with climate-related risks in their regulatory framework. One major specimen of this was when, recently, the Deputy Governor in a panel discussion on ‘Climate Implications for Central Banking’, revealed that the Reserve Bank of India (“RBI”) also intends to eventually issue guidelines for banks on the stress testing of their credit portfolios for climate vulnerability. The regulator’s first step in this process would be to identify the amount of exposure at risk from climate-related events. The aim of this article is to evaluate whether RBI’s move towards green central banking can be aided by regulations in favour of mandating climate-related stress tests for the banking sector or if is it too early for India.
Recognition of the role of RBI in climate risk management
Essentially central banks are immersed in monetary policy, economic growth, financial stability, and the regulation and oversight of the financial sector. They are legally required in many nations, including India, to pursue a specific set of goals. They must therefore handle the risks and dangers that have a bearing on their primary objective. Such a risk is indeed posed by climate change. They must thus control outcomes that might compromise the financial system’s stability as well as the security and robustness of the institutions that operate there.
These central banks, as the quintessential risk managers, play a crucial part in this convoluted task as suppliers of realistic information that can help politicians, business executives, and households identify dangers and take imperative alleviating steps. Moreover, it can be fairly argued that in light of the RBI’s onus to preserve growth momentum and price and financial stability, its neglect to take the economic consequences of climate change into account would amount to regulatory carelessness.
What is climate-related stress testing?
Stress Tests are examinations of banks’ resilience to financial and economic shocks, and these are overseen by prudential regulators. They enable bank supervisors to spot weak points and collaborate with those organizations to mitigate them. Climate stress tests investigate banks’ ability to withstand physical risks brought on by acute and recurring extreme weather occurrences as well as transition risks brought on by new policies and technology. They hinge on several hypotheses regarding potential policy implementation and the capacity of those policies to avert the breaking of crucial temperature thresholds.
These unique exercises encompass several climate shock scenarios as opposed to the economic fluctuations modelled in conventional stress assessments. Furthermore, climate stress tests have been to be learning opportunities for banks and supervisors, in contrast to traditional stress assessments. Typically, they are built around a framework for scenario analysis created by the Network for Greening the Financial System. Although they have been described as learning exercises thus far.
How regulations by RBI can help in mitigating climate risks?
To explain the essential role of regulators such as RBI, an instance can be taken of the scenario analysis mentioned earlier itself, in the sense that these regulators must issue guidance and regulations for banks to perform scenario analysis in order to evaluate potential dangers. It is albeit necessary to share information from these risk evaluations, and doing so would help banks and policymakers alike comprehend the magnitude of the climate challenge. Something like this has been done by RBI prior also for analysing operational risks faced by banks. Scenario analysis can be used to fill in the gaps in the evidence that is lacking regarding how vulnerabilities stemming from climate change should be administrated, starting with discerning their scale by taking into account both past and probable future events. Scenarios can be viewed as hypothetical future occurrences that need to be recorded in terms of their conceivable frequency and loss magnitude. This is just one of the many ways in which regulations by RBI can be sine qua non for climate risk management by banks.
Taking cues from other regulators like European Central Bank
Recently, the ECB published the results of its second climate stress test and its findings demonstrate that accelerating the green shift at an intensity that is quicker than under existing arrangements is the best option for accomplishing a net-zero economy for businesses, people, and banks in the euro region. Furthermore, postponing the shift or doing nothing at all would lead to longer-term losses and hazards that are considerably larger. Missing goals for lowering emissions require less investment overall, but has a major negative impact on the economy and the financial sector due to the increased physical risk.
The aim of mentioning ECB’s findings is not to imply that the results would be exactly same for India also but to make an argument that bringing regulations for banks to conduct these test could result into findings that act as wake up call for Indian Financial system as India is nowhere safe from climate changes which is clearly demonstrated by its position in Global Climate Risk Index, 2021 which ranked India as the seventh-most severely impacted nation by severe weather conditions like storms, flooding, and extreme temperatures. Half of India’s population and 75% of districts, according to different research by the Council on Energy, Environment, and Water, are susceptible to major climate-related catastrophes. In light of all this, surely India also requires such analysis to see the level of threat it faces and the recent move by RBI is a welcome step in pursuance of this.
Numerous other central banks, including the ones in France, the UK, Germany, Japan, China, the Netherlands, Finland, and Malaysia, have also performed or intend to perform scenario assessments and stress tests to evaluate the adaptability of their financial institutions to climate hazards, surely India should also make progressive steps in this endeavour.
Legal dilemmas surrounding climate stress tests
Stress Testing has been employed by the RBI earlier also, to evaluate the degree of strain in the financial sector with regard to non-performing assets, capital requirements, etc. Regulated Entities (“REs”) like banks, can effectively manage climate risks by following the RBI’s stress testing rules (also known as the “Stress Testing Guidelines”) for scheduled commercial banks, which were modified in 2013 and introduced as a reaction to the worldwide financial meltdown in 2008.
However, the regulator must not shy from making considerable adjustments to the system in order to incorporate climate risks into the regulatory and prudential framework for regulated entities. To make sure it can withstand judicial review, the legal requirement for the financial sector watchdog to create a structure for climate funding should also be carefully scrutinized. However, given RBI’s mandate of risk management in the economy and the stark requirement of a concrete and binding environmentally sensitive policy, a carefully drawn-out strategy would likely by upheld as and when it comes under judicial scrutiny.
In addition to this, to properly carry out the regulatory mandate, REs must also be ready to make investments in technology solutions, risk management, governance enhancement, and capacity building. The RBI in this regard would be very influential in determining how the financial industry responds to climate concerns not just from a commercial point of view but also factoring in other relevant considerations like rights and responsibilities of various stake holders, by providing relevant and inclusive guidelines, rules, and policy formulation.
Challenges that can be faced by RBI in bringing out climate stress test regulations for banks
The potential challenges can take form of both general ones stemming from the nature of climate stress tests and specific ones associated with Indian Scenario.
If we talk about general challenges, gauging the effects of climate change necessitates certain core adjustments, for starters, substantially longer time frames than those utilized in respect of traditional banking sector hazards are envisaged for the hazards to materialize. Furthermore, given the ongoing changes in atmospheric patterns, data on foreseeable climate trends may be lacking or incorrect. Furthermore, in order to distinguish and evaluate risks along these dimensions, quantifying the impact of climate risk necessitates comprehensive exposure data, ideally by industry and location. However, such information might not be accessible right now.
Furthermore, modelling methods must be tweaked to facilitate an activity and that must include at least four components. Modelling climatic variables is covered in the first section, measuring the implications of climate on macroeconomic variables is covered in the second, dividing the overall macroeconomic influence into different sectors is covered in the third, and quantifying the comprehensive effect on financial businesses is covered in the fourth. Doing something like this might prove to be arduous and prone to error but important none the less.
If we talk about specific problems concerning India, firstly, Research on physical and transitional risk factors is sparse. Because existing data gathering practices do not meet global norms, the data that is already available is insufficient completely reliable.
Secondly, India’s economy is still in the budding phase of risk mitigation, as opposed to the industrialized economies. The accessibility of data and reliance on regulation are problems that are exacerbated in the banking industry by the standardized approach used by Indian banks to assess capital.
Thirdly, since capital allocation is based on external ratings rather than internal credit ratings, this has a bearing on the data acquisition procedure. Although Indian banks do have internal rating models, the information contained in them is not as thorough as that found on global markets.
Fourthly, but certainly not the last of the problems present, considering how climate change is affecting commercial results, it is anticipated that green initiatives will have acceptable creditworthiness in the long run. The existing crediting rating system, however, fails to reflect for this. The capital and insurance industries are still developing and heavily regulated. This presents a problem because advancement depends on law and not usually on institutional ability within. All these require careful consideration and needed to be addressed for any risk assessment process to bear sufficient fruit.
Conclusion
It is submitted that there is significant model risk that RBI may face which are associated with estimating the effects of environmental change in various scenarios and converting those effects into economic losses, bank loan losses, or mark-to-market adjustments. It may therefore be wise to supplement the balance-sheet or bottom-up strategy of regulatory stress testing with a market-value or top-down strategy that has a better chance of representing changes in market sentiment surrounding climate risk and its effects on businesses, banks, and the larger economy, depending on the assessed data sets and corresponding economic requirements.