Greening the financial system and the role of central banks

Central banks are increasing their efforts to promote the transition to a more sustainable financial system

Summary

Over the last four years, central banks, regulators for banks, pension funds and insurance companies have become the new key actors accelerating the financial sectors’ focus on sustainable and responsible investing.

Climate change has, and will continue to be a key area of focus given the potential risks it poses to financial stability. Central banks have largely been focused on encouraging disclosure among corporates and investors as it relates to climate risk and hence supporting the work of the Task Force for Climate-related Financial Disclosure (TCFD).

Beyond encouraging improved disclosure, we suggest that there is more that central banks can do to support the lowcarbon transition and the Sustainable Development Goals without compromising their mandates. This could be in the form of monetary policy settings, building the evidence base for differentiated capital and reserve requirement ratios, and establishing responsible investment frameworks for centralbank balance sheets, reserves and their own pension funds.

The expansion in central bank balance sheets, the surge in official foreign exchange holdings, most notably among EM central banks, as well as the adoption of more innovative investment strategies by central banks may provide an opportunity for more direct ESG and climate risk related investment strategies.

We suggest that developed market central banks could support their emerging market counter-parts by leading, by example through implementing responsible investment frameworks for their reserves and pensions. For instance, central banks could become signatories to the Principles for Responsible Investing (PRI), require ESG integration in funds/benchmarks, and expect investee and government engagement. In addition, the improvements in climate risk data also permits a more robust integration of physical as well as transition risk into investment portfolios.

The increasing popularity of passive indices and specifically ESG and low carbon investing provides an easy first step for shifting a portfolio towards responsible investment.

Finally, the debate on a ‘green supporting factor/brown penalising factor’ in capital reserve requirements is likely to continue for some time. However, we believe the idea of a green supporting factor for green mortgages is logically compelling and deserves more research. For instance, central banks could examine how they could support the creation of standardised energy efficient mortgages, which could lead to green asset backed bonds. This could provide the evidence basis for considering a ‘green supporting factor’. A ‘grey penalising factor’ could be considered due tothe need to quickly cut emissions.

We believe, the establishment of the Network for Greening the Financial System (NGFS) and central banks’ track record in promoting best practises, places them in a unique position to influence broader financial market behaviors and accelerate the transition to a more socially and environmentally sustainable economy and financial system.

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