The climate transition needs more bank failures

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Suppose for a moment that the central banks and supervisors that make up the Network for Greening the Financial System (NGFS) get most of what they want.

Banks in high-emitting countries like the US adopt net zero as more than just a greenwashing mantra. They coax their clients to reduce emissions and actively support projects they deem to be both creditworthy and likely to engender a sustainable economy. They opt to starve fossil fuel producers of debt finance, further accelerating decarbonization.

Further, suppose these efforts are broadly successful. By 2027, we are running neck-and-neck or slightly ahead of Paris Agreement targets.

In making this progress, using the language that’s very familiar to climate stress testers, banks are rebalancing their portfolios away from physical risks and opting instead to take on a considerable amount of transition risk.

These risks are significant. Because our ability to accurately identify truly green projects is immature and imperfect, banks may opt to fund technologies that turn out to be nonstarters. They will be funding generally younger entities without the decades-long financial track records of most high-carbon entities. Because of the burgeoning enthusiasm fueling the drive to net zero, banks will run the risk of pumping up green bubbles, potentially allowing their enthusiasm for certain investments to run far ahead of their actual net-zero utility.  

In this rosy scenario, we assume the financial industry’s efforts are broadly successful. But this does not mean that dangerous pockets of transition risk are completely absent. Suppose, then, that in 2027 bank failures start to mount. While many make sound bets and remain profitable, others, it turns out, back the wrong horses and see loan losses mount rapidly. The crisis begins with the small and midsize banks that tend to be the most entrepreneurial in spirit. In late 2027, though, a lender the size of Silicon Valley Bank fails and there are murmurs that one of the Big Five US banks is in serious trouble.

Like I said the NGFS – of which the Federal Reserve is a member – has most, but not all, of its wishes come true.

The question is what central banks and regulators should do about this set of circumstances? Should they halt the green push by raising capital charges to astronomical levels? Should they bail out the banks deemed to be systemically important financial institutions (SIFIs) and try to keep the show on the road?  Should they do nothing, concluding that failed banks are simply unfit for the new economic circumstances they face?  

The interesting thing, missed by many, I think, is that avoiding bank crises is a very different goal to achieving climate nirvana. It makes no sense to imagine that controlling bank risk has very much, if anything, to do with saving the planet.

There’s much to unpack here. The first, and most important, point to note is that in our scenario, the overall net-zero strategy is unfolding as planned. The solution to the problem that has dogged mankind for the best part of a century – global warming – is being successfully prosecuted. Pulling the plug on the project just because of a pesky banking crisis seems to be a rather churlish and short-sighted option.

Similarly, doing nothing seems to be a rather extreme form of regulator purity. After all, the raft of bank failures is threatening to derail the economy, which is otherwise coping well with the transition efforts. If a bailout or two would help keep things ticking over, and keep the march to net zero on track, I think the government should act accordingly.

The final point to note is that the suggested bailouts themselves are – potentially – a lot more palatable than those undertaken in the past. During the global financial crisis, for example, banks failed because they were gorging themselves on nebulous profits from dodgy mortgage loans. Banks were capitalizing on the upside while sticking taxpayers with the downside risks associated with their lending activities. Much of the public were justifiably angry that the most egregious bankers escaped punishment while failed homeowners suffered terrible losses.  

The situation described here is very different. The failed banks in our hypothetical 2027 crisis were trying to help solve a major problem for humanity. They were funding efforts to address global warming, but alas the decisions they made turned sour. Their motives were not completely pure – they were trying to profit – but their actions were not completely venal either.

One suspects that a large chunk of society would herald these failures as proof of the folly of fighting climate change, but these folks would be on the wrong side of history. A larger chunk would appreciate that the banks had a go but unfortunately were unsuccessful in their efforts.  

And, critically, the surviving banks would be financing the sustainable world we all want to see.  A “green banking crisis” would cull certain institutions, yes, but would help the surviving banks understand how to navigate the emerging net-zero economy and manage transition risks. As things stand we can only guess which are the best strategies to pursue.

All in all, a transition-fueled banking crisis, while far from pleasant, would have a number of positive ramifications. Most importantly, it would power us on our way to solving the climate crisis.