Changing the Climate of Financial Regulation

Sarah Bloom Raskin

DURHAM – As this year’s brutal summer showed, it has become increasingly easy to track the consequences of climate change.

Just as extreme weather is claiming more and more human lives, more and more species are being lost to extinction. Entire communities have been displaced by savage storms and intolerable temperatures, and rising sea levels and unstable agricultural production threaten to destroy millions of jobs.

These costs are no longer theoretical or far off. They are here now, and though they are being shouldered across the board, the people who feel them most intensely have less access to information, work outdoors, or live in insufficiently protective conditions.

Those who cannot easily relocate or afford sufficient property and casualty insurance are increasingly vulnerable.

Despite these growing costs, US financial regulators have yet to show that they are thinking creatively about potential solutions.

Their reluctance stands in stark contrast to financial regulators in other rich countries, where policies and processes are being reimagined to accelerate a rapid, orderly, and just transition to a renewable, biodiverse, and sustainable economy.

Institutions like the European Central Bank, the Bank of England, the Bank of Japan, and the Bank for International Settlements are actively working to repurpose instruments like stress tests, living wills, and risk-based capital standards – all within their existing mandates.

They are also pursuing new alliances with local regulators to bridge the regulatory gaps between the financial sector and the shadow banking system.

To be sure, the US financial regulatory structure is complicated, consisting of regulators in a wide range of siloed agencies with discrete statutory mandates.

A non-exhaustive list includes the Federal Reserve System, the Securities and Exchange Commission, the Federal Housing Finance Agency, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Consumer Financial Protection Bureau, and the Comptroller of the Currency.

But even though the United States lacks a single monolithic financial regulator, the complexity of its regulatory apparatus need not imply climate inaction.

While none of its regulatory agencies was specifically designed to mitigate the risks of climate-related events, each has a mandate broad enough to encompass these risks within the scope of the instruments already given to it by Congress.

Accordingly, all US regulators can – and should – be looking at their existing powers and considering how they might be brought to bear on efforts to mitigate climate risk.

In light of the changing climate’s unpredictable – but clearly intensifying – effects on the economy, US regulators will need to leave their comfort zone and act early before the problem worsens and becomes even more expensive to address.

This imperative means two things. First, regulators must move faster in preparing firms within their jurisdiction to weather climate effects that are not being eliminated by markets.

Second, they need to ask themselves how their existing instruments can be used to incentivize a rapid, orderly, and just transition away from high-emission and biodiversity-destroying investments.

Acting before any major crisis has occurred is not exactly the American way. Historically, US regulators have preferred to rely first on market discipline and private-sector initiative.

Only when those fail have they intervened to mitigate the damage (almost always at taxpayers’ expense).

Many readers will recall that this was the general approach taken in the 1990s and early 2000s when the government sought to engineer artificial prosperity through dangerous forms of homeownership.

Thousands of derivatives were allowed to bloom. As financialized home mortgages lured in more and more Americans, federal regulators ignored signs of predatory lending, the systemic steering of racial minorities into complex and confiscatory subprime loans, and rising waves of foreclosures.

The result was a full-blown crisis that caused trillions of dollars in losses. Only then did regulators rush in to revise their policies, rein in their permissions, identify the obvious consequences of failure, and figure out what changes to laws and rules were needed to prevent a reoccurrence.

Sadly, this is a deeply entrenched pattern. In the savings and loan crisis of the late 1980s and early 1990s, it took the sector’s collapse to lead to the statutory creation of corrective measures.

Fast-forward to today, and the default assumption of many US regulators is that a smooth transition from the historically embedded carbon-based economy to the renewables-based and sustainable economy of the future will occur on its own.

Embracing this default assumption is like taking your hand off the rudder when navigating a narrow passage between dangerous currents.

We should not act as if there were no navigational instruments to assist us. Yet that is effectively what US financial regulators are doing by not exploring the possibilities offered by the tools at their disposal.

The most prudent course is for each financial agency to start acting immediately within its respective remit, rather than diverting its expertise into well-worn debates about whether climate-related harms do or do not represent collective harms to society.

The complex, non-monolithic nature of the regulatory system should be recognized as a virtue. While the system’s structure sometimes leads to a lack of coordination and a degree of bureaucratic close-mindedness and insularity, it also means that each agency can act creatively on its own, introducing diverse solutions based on a broad array of perspectives.

Moreover, thanks to federalism, regulatory experimentation can be carried out on a smaller, regional scale to establish proof of concept.

Existing coordinating bodies like the Financial Stability Oversight Council can then pick up some of this work, depending on existing membership and the scope of US President Joe Biden’s May 20, 2021, Executive Order on Climate-Related Financial Risk.

More broadly, though, US regulators need to be encouraged to think more imaginatively about how they can engage with local transition efforts.

For example, how might financial policies from diverse agencies be stitched together to produce outcomes that enable firms to hit their net-zero targets?

How can financial policy be used to help accelerate a transition that redeploys workers for new jobs, or to assist households that are being asked to change their spending habits?

And how can regulatory changes relating to disclosure, access to credit, and pricing of risk support a rapid and just green transition?

While financial regulators repurpose their instruments and reimagine their processes, financial firms should be doing the same, acting now to identify their environmental assets and liabilities, rather than waiting for slow regulators to do it for them.

When an institution knows what it has in its portfolio, it can anticipate how it will fare in the face of successive climate-related shocks, and it can better determine correct asset pricing and valuations, as well as the adequacy of its reserves.

In short, neither industry players nor regulators should wait around for someone else to tell them what to do and when to start.

Most of the necessary tools are already there. What is lacking is a willingness to break the habit of acting only after a disaster.

Financial regulators must reimagine their own role so that they can play their part in the broader reimagining of the economy.

Sarah Bloom Raskin, a distinguished fellow at Duke University School of Law’s Global Financial Markets Center and a senior fellow at the Duke Center on Risk in Science & Society, is a former deputy secretary of the US Department of the Treasury and a former governor of the Federal Reserve Board.

Copyright: Project Syndicate, 2021.