Will the greening of central banks survive a crisis?

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Apologies for the late running of this newsletter. Louie was rendered temporarily inconsolable by England’s Euro final defeat. Tony, as an Australian, was mercifully unaffected.

During and after the Global Financial Crisis (GFC), central banks around the world – most notably the US Federal Reserve – purchased large quantities of mortgage-backed securities (MBS).  The epicenter of the crisis was the US market for subprime mortgages, which had grown like a weed in the years after 9/11.   Growth was fueled by a number of dubious innovations in the secondary market for mortgages.   

By 2007 many banks were heavily exposed to bonds collateralized by toxic mortgages and were rendered insolvent when the market for such assets collapsed.  Some were bailed out and some, including Lehman Brothers, were allowed to fail, triggering a range of market conniptions.  Counterparty trust eroded, market liquidity seized, and a deep recession raged.  

The Fed stepped in to provide liquidity and to act as buyer-of-last-resort for toxic assets.  These actions helped head off the threat of an even deeper financial crisis.  In the estimation of some, it prevented a repeat of the Great Depression of the 1930s.

Though the Fed ultimately profited from many of its asset purchases, this was not the motivation for initiating the transactions.  Central banks are not run with commercial sensibilities.  Their “shareholders” are ultimately the citizens of the countries whose financial systems they oversee.  If it is in the public interest for a central bank to take an action that would be considered boneheaded or reckless by a profitable private corporation, then that’s precisely what they must do.  The Fed’s actions during the GFC illustrate this clearly – private buyers of MBS in the late 2000s considered the assets to be excessively risky, but the central banks fulfilled their duty and bought them anyway.

I bring up this example to help peel the onion on a recent NGFS report on the greening of central bank market operations.  

Here’s what I think: if you consider the potential role of a central bank in promoting the national (and global) interest, if you do this independently of any misgivings you may have over the extent of the bank’s mandate, and if you recognize that financial markets are currently functioning as they are supposed to (give or take), the actions proposed by the NGFS are unquestionably valid and reasonable.  

One of the prime consequences of expunging “dirty” emissions-intensive assets from central bank balance sheets, an action explored by some institutions, including the European Central Bank, is that it will increase the cost of finance associated with such activities.  This will accelerate the push for net zero and improve our chances of finding salvation from the unfolding climate crisis.  Even if there are unforeseen problems with the strategy, the aim is so important that it must at least be attempted.

I support the action generally but would prefer it if the central bank’s mandate were extended to definitively cover the required actions.

Back in the real world, there are several problems and inconsistencies with the NGFS message that must be digested.  The NGFS is a consortium of national central banks, each of which has a solemn duty to the citizenry whose interests they represent and constraints on the range of actions they are allowed to pursue.  They have priorities.  Climate risk has become an important consideration for NGFS members but it would be naive to imagine that it is at the very top of the list.  

We must bear in mind that while the drive for net zero may be helped along by central banks, legislatures are the ones who are ultimately responsible for pursuing climate goals. We should always vote according to our consciences.

Central bank actions during a hypothetical future crisis

During periods of market stability and economic expansion, central bank operations are normally designed to be agnostic with respect to the investment choices made by private entities.  The mix of securities on the central bank’s balance sheet will be broadly in line with the overall marketplace, minimizing the potential for price distortions.  The constitution of the bank’s book is normally fairly uncontroversial.

As mentioned, the NGFS is proposing that central banks reduce their exposure to dirty assets in order to help manage climate-related risks and to make their operations consistent with an orderly transition to net zero.

Financial markets are currently fairly quiet, meaning central bank actions of this type are unlikely to cause upset. But it’s during periods of crisis when central bank actions become much more pertinent.

First, let’s imagine a generic banking crisis caused by something unrelated to climate change.  The banks that are sliding into insolvency, in terms of their climate-sensitive holdings, represent a broad cross section of institutions.  Some have been vigorously pursuing net-zero strategies while others have been dragging their feet.  The crisis is indiscriminate, impacting green and not-so-green banks alike.  But assume that the largest, most consequential at-risk institution also happens to be one of the dirtiest.

The scale of events is equivalent to a repeat of 2008.  

Say you are the Fed Chair. What actions would you take?  Would you follow the NGFS’s tenets and allow the market for dirty assets to seize, triggering the failure of a number of banks (including at least one that is too-big-to-fail)?  Would you bail out the clean banks only?  Would you let the crisis unfold without interfering, triggering a depression that would set back the push to net zero by a decade or more? 

Or would you choose to increase the central bank’s exposure to dirty assets?

If the banking crisis is caused by a realization of excessive climate-related risk, the situation changes only in terms of the composition of the purchases. The response to such a crisis would be dominated by the buying up of a range of environmentally unwise assets.  In the generic crisis, the dirty purchases would almost certainly occur too – but they would be incidental.  I suspect that one crisis – especially a climate-related one – would swamp any progress on greening central bank balance sheets that might be made during the quiet period.

In other words, there are no green central bankers in a foxhole.

Imagine there had existed a Network for Safe Mortgage Backed Securities (the NSMBS to insiders), which implored members to remove exotic MBS from central bank balance sheets in the 1990s or the early 2000s.  They might have gained some early traction from their efforts.  After all, no pre-GFC central banker would have told you that holding excessive amounts of MBS – including a lot of complete junk – was a particularly good idea.  

After the GFC, the NSMBS’s reports would have seemed to be exceptionally naive.  

I suspect that this will be the fate of the NGFS’s recent work should it ever be tested by a broader banking crisis.