ZEUS: Climate warnings to banks begin to add up

Financial crises are usually caused by events nobody sees coming. Here's how climate change falls into that category

Above, a scene from Paramount Pictures’ The Big Short, 2015.

(David Callaway is founder and Editor-in-Chief of Callaway Climate Insights. He is the former president of the World Editors Forum, Editor-in-Chief of USA Today and MarketWatch, and CEO of TheStreet Inc.)

SAN FRANCISCO (Callaway Climate Insights) — In the movie “The Big Short,” the Michael Lewis story about a small group of investors who saw the Great Financial Crisis of 2008 coming a few months ahead of time and made a fortune, the collapse of the banking system came suddenly and without warning.

In reality, the derivatives trading inspired by lack of regulation and a wildly, out-of-control U.S. real estate market was warned about more than two years beforehand, with the advent of the subprime lending crisis. Like with most disasters, the warnings were generally ignored until it was too late.

In the teeth of the storm of Covid-19, the racial justice crisis, and the U.S. presidential election this year, investors could be forgiven for missing yet more warnings from scientists about the coming climate changes and the wildfires, storms and floods they will cause. But the warnings are getting closer to Wall Street, and more specific.

A report by Commodity Futures Trading Commission last month outlined for the first time the “systemic risk” to the financial system of climate change. In it, a diverse group of banking and asset management executives warn that without stress testing on bank lending and capital requirements, and a carbon price, the financial system runs the risk of another loans and derivatives crisis. The report made a brief splash, then fell into the abyss of political branding and motive questioning.

This week, another report surfaced, warning that the largest U.S. banks have dramatically understated the risk to their syndicated loan books from climate change policy changes or sentiment shifts. In a nutshell, the report from the Ceres Accelerator argues bank lending to fossil fuel companies, while extensive, presents the risk of only modest losses to the big banks should they go away.

But when you add in the risk of lending to other industries impacted by climate change, such as agriculture, construction/buildings, and transportation, that risk leaps to more than half of their loan books. JP Morgan (JPM), Citigroup (C), Morgan Stanley (MS), Goldman Sachs (GS), and Bank of America (BAC) are all named in the report.

The key here for investors is what Ceres describes as key finding No. 3. It’s not just that they could suffer from losses tied to loans in several major industries, it’s that the rapid deterioration of their balance sheets could render them unable to loan to each other. This is what happened to Lehman Brothers and Bear Stearns in 2008.

Neither report hazards a guess at what could spark such a financial wildfire, except to say a sudden policy change, or shift in investor sentiment brought on by a climate event. Financial stocks are among the losers in this year’s market rally, having fallen dramatically in March with everything else and only slowly clawed their way back toward those levels. They remain a great bet if you believe in a big-spending, pandemic recovery next year led by renewable energy stocks. But they are exposed to the shock of disorderly shift in investor sentiment about the cost of climate mitigation.

A dozen years ago, the risk of highly-leveraged real estate derivatives was out there in plain sight, but as long as they kept rising, nobody wanted to be the first to sell. The unraveling caused the worst financial crisis since The Great Depression, and spread to economies around the world, some of which have not regained their full footing.

Climate change is hiding in plain sight, too. In the fires in Colorado, California, the Arctic and the Amazon. In the hurricanes, and the everyday flooding we see in some U.S. cities. What these reports are flagging is that everybody sort of sees this coming, but once it tips, the financial impact could be far greater than we’re prepared for.

Equity markets are at historic highs. They are pricing in a robust Covid-19 recovery next year, despite the surge in cases in Europe and the U.S. this month. Third-quarter financial earnings were pretty good, led by healthy trading profits. Behind the headlines, banks should be stress testing for the possible contagion tied to a climate event. The warnings are starting to add up.

The media likes to call unexpected events Black Swans, but risk expert Michele Wucker labeled climate and Covid “Gray Rhinos,” for dangers that are highly probable but still neglected. The rhinos will make for a much better movie someday.