Climate Change And Banking: Who Will Insure The Deposit-Insurers?

Deposit insurers play a critical, albeit often invisible, role in maintaining the stability of financial systems worldwide. These institutions provide a safety net for depositors, ensuring that in the event of a bank failure, their deposits are protected up to a certain limit. This not only fosters trust in the banking system but also helps to prevent bank-runs and maintain overall economic stability. However, as climate change exacerbates financial risks, the resilience of deposit insurers is being put to the test like never before.

Climate change presents a myriad of financial risks that are complex and multifaceted. These include physical risks such as damage to property and infrastructure from extreme weather events, as well as transitional risks arising from the shift towards a low-carbon economy, as well as brown to green asset base. Financial institutions, including banks, are increasingly exposed to these risks, which can lead to significant losses and heightened instability within the financial system. Consequently, the task of deposit insurers becomes even more challenging as they must navigate these emerging threats to safeguard depositor funds and uphold confidence in the financial system.

One of the primary concerns is that climate-related risks can cause a domino effect within the financial sector. A significant climate risk is the possible emergence of stranded assets, particularly in sectors like fossil fuels, where assets may rapidly lose value as climate policies become more stringent. This depreciation can lead to lower recovery rates when resolving failing institutions, posing severe challenges to the long-term financial sustainability of deposit insurers and complicating the strategies of resolution authorities. For instance, a bank heavily invested in industries vulnerable to climate change, such as fossil fuels or agriculture, could suffer substantial losses as these sectors face increasing climate-related disruptions. Such losses could erode the bank's capital base, making it more susceptible to failure. In this scenario, deposit insurers would be called upon to protect depositors, potentially straining their resources and challenging their capacity to fulfill their mandate.

To address these risks, regulators globally must frame comprehensive ESG (Environmental, Social, and Governance) policies that incorporate elements of climate sustainability, investment in sovereign green bonds, and the impact of climate change on default risk. Furthermore, contingency planning for climate-related extreme events via actuarial analysis is essential.

However, the challenge is that ESG frameworks themselves, globally and particularly in India, are evolving and yet to be standardised and homogenised for local conditions. Central banks like the RBI need to enhance the frequency and harshness of climate resilience stress test of the banks they supervise and upgrade the deposit insurance response to climate change. This includes guidance for their regulated entities to stress test their asset portfolios to assess the impact of climate change, strengthening payment systems’ resilience to climate risks, developing climate risk disclosure norms for REs, and regularly updating the climate-risk management framework.

Framing a comprehensive ESG policy is crucial, including concepts like additionality, permanence, measurability, verifiability, uniqueness, and avoiding social and environmental harm. Additionally, it ensures that investments create environmental benefits that would not have occurred otherwise. Permanence addresses the longevity of these benefits, ensuring they are enduring. Measurability and verifiability are crucial for assessing and confirming the impact of investments, while uniqueness prevents the double-counting of benefits across different projects.

Enhancing regulations through a green taxonomy is urgent to define green investments clearly. A green taxonomy provides a clear definition of what constitutes a green investment, offering transparency and consistency in identifying sustainable economic activities. This clarity helps investors make informed decisions and aligns financial markets with environmental objectives. It ensures that capital flows into genuinely sustainable projects and prevents greenwashing, where investments are falsely marketed as environmentally friendly.

Climate risk-based differential premiums, supported by ex-ante funding, can incentivise green finance by making environmentally risky investments more expensive and rewarding sustainable ones. This system encourages financial institutions to shift their portfolios towards green assets. However, without proper mechanisms and support, such premiums may initially discourage banks, particularly those heavily invested in carbon-intensive sectors. Therefore, regulatory bodies must provide guidance and support to help banks transition smoothly, including technical assistance and capacity-building initiatives.

Global South nations, including India, are particularly vulnerable to climate change and need climate risk-adjusted deposit insurance as a safety net. These nations face a double whammy: on one side, they suffer from the broken promises of developed countries to fund climate action, delaying their climate action possibilities; on the other, their current economic state makes them victims of climate ironies.

Unchecked climate stress tests exacerbate this situation. Stress testing is a critical tool for assessing how financial institutions can withstand adverse conditions, including those brought about by climate change. However, if these tests do not rigorously account for climate risks, they can paint an overly optimistic picture of a bank’s resilience. This false sense of security can lead to inadequate preparations and insufficient capital buffers, increasing the likelihood of bank failures during climate-induced crises.

Banks must provide clear and detailed information on how they are addressing climate-related risks, allowing depositors and investors to make informed decisions. This is where a detailed regulatory framework that can enable standardised disclosures by banks to public stakeholders can build trust in climate action by the financial sector.

Deposit insurers, though unseen and unsung, are indispensable to maintaining financial stability. In India, deposit insurance is managed by the Deposit Insurance and Credit Guarantee Corp., which was established under the Deposit Insurance and Credit Guarantee Corporation Act of 1961. As a wholly owned subsidiary of the Reserve Bank of India, the DICGC provides insurance coverage to depositors in case of bank failures, protecting balances up to Rs 5 lakh per depositor. Additionally, the DICGC offers credit guarantees for bank loans, further enhancing the stability and credibility of the Indian banking system.

As climate change intensifies, their role becomes even more crucial. Deposit insurers must adapt their strategies to these new realities. Developing sophisticated risk modelling techniques that account for climate-related factors and adjusting reserve requirements accordingly is critical. Their efforts must be supported by comprehensive regulatory frameworks, international cooperation, and robust risk management strategies to navigate the challenges posed by climate change effectively.

The fundamental question then arises: who will insure the deposit insurers? As climate risks escalate, deposit insurers themselves may require a form of reinsurance or a back-up mechanism to ensure they can withstand large-scale claims. Traditionally, deposit insurers have relied on their own reserve funds and, in some cases, government backing to meet their obligations. However, the unprecedented scale and unpredictability of climate-related financial risks necessitate a re-evaluation of these support structures.

Srinath Sridharan is a policy researcher and corporate advisor.