The banking sector is vulnerable to climate-related risks, according to a study by the South African Reserve Bank. Picture: Kanchanachitkumar
A recent working paper from the South African Reserve Bank (SARB) has highlighted a significant risk to the nation's banking sector due to its exposure to climate transition-sensitive economic sectors.
The paper, titled "Transition and Systemic Risk in the SA Banking Sector" was published on July 22, and underscores the potential systemic risk posed by climate-related financial exposures.
Authored by Pierre Monnin, Ayanda Sikhosana, and Kerschyl Singh, the paper reveals that approximately 35% of South African banks' corporate credit exposure is directed towards sectors sensitive to climate transitions.
These sectors include fossil fuels, utilities, energy-intensive industries, transportation, and agriculture. If the building sector is included, this exposure could soar to as high as 60%, equating to nearly R1 trillion.
"Climate-related risks, including transition risks, are significant financial risks and represent a potential systemic risk for the financial system," stated Monnin, Sikhosana and Singh.
The authors highlight that the financial repercussions of transitioning to a low-carbon economy could be profound, potentially destabilising the financial system.
The paper's analysis is particularly focused on the banking sector's corporate loans, which amount to about R2.8 trillion. The exposure to transition-sensitive economic sectors could lead to amplified risks within the financial system, particularly if shocks to these sectors are transmitted throughout the economy.
The paper suggests that for every job lost in the coal sector, more than two additional jobs could be at risk in other sectors, with the motor sector facing slightly lower risks.
Can climate-related risks cause widespread financial problems?
The authors believe that climate-related risks, including those related to the transition to a greener economy, can cause major problems for the financial system. These problems, known as systemic risks, can disrupt financial services and harm the economy. Systemic risks happen in three main ways:
Systemic Risk-Taking - Financial institutions (like banks) all invest in the same kinds of assets, leading to large and interconnected risks.
Contagion - Problems at one financial institution spread to others because they are all connected.
Amplification - Small shocks grow bigger because of factors like leverage (borrowing) and panic selling in financial markets.
The SARB study indicates that climate-related risks can trigger systemic risks in all these ways.
They affect everyone, households, businesses, and governments, across all sectors and regions, making it hard to protect against these risks through diversification.
Banks are especially exposed to these risks because they lend a lot to high-risk sectors. For instance, in Europe, banks lend much more to high-emitting sectors compared to their overall economic share. This makes banks more vulnerable to climate-related risks.
The study highlights that some banks and financial institutions are more exposed to these risks than others, and within the banking sector, the risk is not evenly distributed. Weaker banks may face higher exposure.
There is also concern that financial markets do not fully account for climate-related risks. If they suddenly start doing so, there could be large and rapid changes in asset prices, causing significant financial losses worldwide.
Finally, the SARB study points out that climate-related shocks can be made worse by financial markets. An initial problem at some banks could spread to others through their connections.
Leverage can amplify these effects, and initial shocks can lead to panic selling, making the situation worse.
A critical recommendation is for central banks and financial sector supervisory bodies to enhance their macro-prudential toolkits, which include capital buffers to bolster resilience against systemic shocks.
In simple terms, the study recommends that central banks and financial regulators need to improve their tools and methods for protecting the financial system from major disruptions. This includes setting aside extra money (capital buffers) to help banks withstand potential economic shocks caused by the transition to a low-carbon economy.
By doing this, they aim to make sure the financial system remains stable and can handle any sudden changes or risks related to climate change. The study also advocates for a shift towards forward-looking data to more accurately model the impact of climate-related financial risks.
"Central banks and financial supervisors are actively participating in this effort, but most of them are still in the evidence-gathering phase. The shift also requires the development of new sets of indicators," Monnin, Sikhosana and Singh wrote.
"Ideally, these should capture the exposure of the financial system to climate-related risks, but also how financial institutions intend to adapt their business models to mitigate these risks, including through their contributions to aligning the economy with an early and orderly transition."
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