Chapter Six The Regulation Perspective

The Regulation Perspective

Steven Lizars Sustainable Finance Partner at Deloitte, Trustee of the Soil Association and former Investment Banker

The global financial crisis of 2008 and onwards will have left no one in doubt that the financial system pervades and interconnects across our economic systems from global to local.

“If anyone doubted it, the GFC demonstrated that an understanding only of historic risk, is insufficient. Day after day of financial events that models suggested should happen only every hundred years meant a new lens for understanding risk was needed.” Steven Lizars

In this conversation One Question asked how regulation in the financial sector can drive positive momentum in addressing change and what role education has to play.

Financial regulation takes many forms, from the financial resources that banks and investment firms must maintain to meet their commitments through to disclosures, transparency, and conduct. As Lizars explained, regulation has expanded significantly. Banks hold significantly more capital in reserve to absorb shocks and regulators have required stress tests to understand whether this capital is sufficient to absorb losses during a range of changing scenarios.

A good example is in relation to environmental related risks. In April 2019, the Bank of England published a supervisory statement relating to climate risk and how banks and insurers should think about the financial risks that emerge from it. This includes the physical risks associated with climate change; but, also the socalled transition risks associated with customers, industries and assets who may incur significant costs to transition themselves to be fit for a low carbon economy. In 2001 the Bank of England required banks to undertake a forward-looking stress test based on climate scenarios.

Front and centre of the movement to decarbonise financed emissions is education. Banks must educate themselves on the greenhouse gas emissions that their customers are responsible for and that the banks are in essence financing. As Lizars says, once understood, banks have a strong incentive to help customers reduce this risk, educating them and helping them make the transition to lower emissions. “Stress testing has been a particularly useful tool for regulators. The lessons learned act to inform the banks and regulators, but importantly this influences how banks act in the future and the lessons learned are therefore transmitted to the broader economy.” Steven Lizars

“Not only are banks needing to incorporate the lessons they have learned from understanding these risks, but there is supporting regulation to require disclosures of them. Banks have a strong incentive to work with their customers to reduce climate related risks.” Steven Lizars

There are other areas within the broader E of ESG where regulation and disclosure are developing, and in turn driving education and change. In 2020 the Dutch Central Bank, the DNB, published a paper exploring the risks associated with biodiversity loss for the Dutch financial sector. The Taskforce on Nature-related Financial Disclosures, funded by NGOs and Governments, is currently working towards developing frameworks to allow organisations to report and act on nature-related risks.

The public policy objectives that shape regulation within the banking sector are multi-faceted and extend beyond ensuring responsible and prudential management of risk. Treating different types of lending or borrowers more or less favourably in terms of the capital that must be held against the risk from a regulatory perspective, can create economic incentives for banks to act in a certain way and promote a favoured environmental or social outcome. There have been calls to positively incentivise

certain types of green lending for instance. However, as Lizars observes, if ultimately banks carry too little capital for the risk they are taking, then the overarching public policy of a safe and sound banking system may be compromised.

Ultimately,effective regulation can act to leverage the interconnectivity of the financial sector across our economic system for good. By driving awareness of climate and other environmental risks and stimulating engagement, and innovation on how to address it, we create the prospect of positive change. Lizars is cautious about the challenges of execution and delivery but optimistic about the ambition he sees. As he observes, the current cadre of bank leaders are keen to shake off the opprobrium that has often followed the industry since 2008 and be part of a positive change.