"From mission to supervision"
Key note speech by Klaas Knot at the Bundesbank Symposium
'Banking Supervision in dialogue'
Frankfurt, 7 March 2018
In his keynote speech, Klaas Knot outlines how the issue of 'sustainability' got on the DNB
agenda, highlighting how and why sustainability is relevant for central banks, supervisors and
the financial industry. Secondly, he gives an overview of the climate-risks in the Dutch financial
sector. Third and finally, he sketches what this means for bank risk management and supervision.
Introduction
Dear herr Dombret, herr Otto, thank for your kind introduction, and thank you very much for
having me. It's a great privilege for me to speak to you at this Symposium Banking Supervision in
Dialogue.
Let me begin though by highlighting that if I would have told you 5 years ago that today at this
very Symposium "Bankenaufsicht im Dialog", we would spend half the day discussing
sustainability, not only would none of you have believed me, but most likely many of you would
have taken me for a sort of tree hugger rather than a central banker.
And yet here we are today. It's a clear indication of the significant shift in thinking that has
occurred in the financial sector and in the supervisory community over the past few years.
Sustainability has become more and more part of mainstream finance, evidenced by so many
initiatives and examples worldwide, of which the Sustainable Finance Action Plan, which the
European Commission will publish tomorrow, is only just the latest.
At De Nederlandsche Bank, which is both the central bank and the supervisor of banks, pension
funds and insurance companies, we have been active on the issue for a few years now. I can
imagine though that many of you might be wondering why we have been active on this issue for a
few years already. What happened there?
Today, in my speech 'From mission to supervision', I want to share with you precisely what
happened. I will firstly share how this issue got on our agenda, highlighting how and why
sustainability is relevant for central banks, supervisors and the financial industry.
I will then turn to a thematic review of climate-risks in the Dutch financial sector that we did in
2017, which led to a publically available report, called Waterproof. As Andreas has already
explained to you how and why our economies and financial sectors could be impacted by climate
change and the energy transition, I will not bore you with repeating that. Instead, I would like to
share with you the outcome of our thematic review on the risks we are seeing for the Dutch
financial sector.
Third and finally, I will say a few things on what this means for bank risk management and
supervision.
All in the hope that we all will walk away here with a better understanding of how sustainability
can affect our different organizations. And convinced that it makes perfect sense to incorporate
sustainability into our day-to-day operations.
I. Mission: Sustainability on the agenda of DNB
Let me begin by explaining how sustainability got onto the agenda of DNB, thereby also showing
in the process why this issue fits the mandate of central bank and supervisor. You see, not too
long ago, sustainability to us just meant we should ensure that our coffee cups were made out of
sustainable paper, and that the coffee in those cups was fair trade. Sustainability was something
we certainly thought that was important, but it was not something that concerned our core tasks
or our strategy as an organization. (And I'm guessing we were not the only organization to think
like this.)
That changed in 2011 though, when the newly appointed board of DNB concluded that probably
this was the appropriate time to update the mission statement. We had to answer the question:
what is our Existenzberechtigung? It's something I'm sure many of you have had to deal with
as well, whether as a supervisor or as a commercial bank. Mind you, this happened in 2011, when
we had just lived through the Global Financial Crisis. Europe was still in the midst of a sovereign
debt crisis, and emergency measures were taken all around us. It had become clear to us, the new
board, but also to many bankers and many economists we talked to, that a significant part of the
economic prosperity that our societies had created in the early 2000s, had been based on
excessive leverage. Our economies had seen too much credit growth, which was not adequately
backed up by underlying strong economic and financial fundamentals of companies, households
and even of governments. All of these developments were in the back of our mind when we had
to come up with that new mission statement for DNB.
One obvious implication of all of this being at the back of our mind, was that safeguarding
financial stability was to be a crucial part of this mission. Another implication was that we
wanted to incorporate an element of the general good of the societies we serve, contributing to
increases in living standards and prosperity of those we serve.
But there was something more, relating to all those crisis developments I just mentioned. Hadn't
the crisis taught us that the prosperity we had created in the years before the financial crisis, had
proven to not be durable in the long run? Put differently, the prosperity had turned out to not
be sustainable. Because that's what sustainable means: durable in the long run.
And so, as we were walking down a foggy beach in Zandvoort, trying to come up with this new
mission statement, we fortunately had the clarity of mind to add the word 'sustainable' before the
word 'prosperity'. Our mission as central bank and supervisors became "to safeguard financial
stability and thus contribute to sustainable prosperity in the Netherlands."
Now, of course, as we added the word 'sustainable' to our mission, our main thinking was in
relation to the economic and financial crisis. Sustainable prosperity meant, for example, that
banks should have sufficient buffers to absorb unexpected losses. But it soon became clear that
the word sustainable could have broader implications.
After all, if the way in which prosperity is created today results in significant ecological damage
that prevents future generations from obtaining similar or higher levels of prosperity, today's
prosperity creation is not sustainable either. And as such, it runs counter to our mission.
Of course, having a mission is just the start. As I'm sure all of you know, any policy determined at
the top needs to be embedded throughout the organization to be truly effective. Therefore our
policy became to incorporate relevant sustainability considerations in most of our core
tasks. Of course the extent to which sustainability can and should be incorporated, depends on
each of the individual tasks that a central bank/supervisor may have.
And I'm sure that the extent to which sustainability can and should be incorporated for financial
institutions, will not only depend on which type of institution you are - a bank, a pension fund or
an insurer - but may also differ per institution as well.
For some of our own core tasks, it was quite practical. In our payments systems task, for
example. We are probably one of the only central banks in the world where 70% of our bank
notes are now made out of either fair trade or organic cotton, and our goal for 2019 is to reach
100%.
For other core tasks, it was more conceptual and theoretical. As part of our economic research
and advisory function, we published an exploratory study called Time for Transition. In it, we
identified the upcoming energy transition, as agreed upon by more than 190 countries in Paris in
December 2015, as one of our economy's key long-term challenges. In the report we urged our
government to pursue a plausible and practicable path towards a carbon-neutral economy, as
such a long-term view enables households and businesses to gradually adjust their investments,
preventing excessive misallocation.
And we also decided to take a closer look into climate risks for the Dutch financial sector as part
of our supervisory mandate.
II. Risks: a thematic review of climate risks in the Dutch financial sector
Which brings me to the second part of this speech. What are the risks that we see as a supervisor
in the Dutch financial sector? In 2017 we conducted a thematic review on this issue. In this
review we took a deep dive into four topics:
- climate-related damages for the insurance industry
- risks for the financial sector from a potential flood
- risks from the financing of carbon intensive assets, so called 'brown finance'
- risks from the financing of assets and projects that are meant to contribute to
the energy transition, so called 'green finance'.
Today I want to share with you some key findings for banks, regarding the risks for brown and
green finance. In terms of brown finance, one of the things we wanted to do was get an
understanding of the size of the risks. How big of a risk is the energy transition for our banking
sector? As a first step, we wanted to measure how exposed our financial industry is to sectors
that need significant reforms to become carbon neutral. Sectors such as fossil fuel producers, the
utilities industry, heavy industry, agriculture and transportation.
This wasn't something that we could easily get from our supervisory data. Which is why we
welcome the work that the Commission will do on developing a taxonomy for the sustainability
of financial assets as part of their Sustainable Finance Action Plan.
For our research, however we had to develop our own template for our financial sector to fill out.
We sent this template to the three biggest banks, covering around 70-80% of the market. What
we found is that banks' balance sheet consist of around 11% of exposures to carbon intensive
industries.
Not surprisingly, most of these exposures are through loans, which makes banks less sensitive to
market fluctuations than for example pension funds. Moreover, most of these loans have
maturities of less than five years, which should provide banks with sufficient scope to anticipate
changes. Especially if the transition is more gradual in nature.
In one area however, we already see transition risks materializing, and that's in the real estate
sector. The real estate sector plays an important role in carbon emissions and is therefore
sensitive to the energy transition. In the EU, many, if not all, residential and commercial real
estate have energy efficiency labels, ranging from A to G, with G being the least energy efficient
building. The Dutch government has announced legislation that requires almost all offices in the
Netherlands to have a minimum energy efficiency label of C by 2023. Any office that doesn't meet
that requirement can no longer be used.
This affects banks in two ways. First, through loans to regular corporations, who use their own
offices as collateral for their bank loans, and second, through loans to commercial real estate
companies that lease offices as a business model. If some of these offices may no longer be used,
or will need to be upgraded to meet the requirement, this could affect the value of the collateral
or the ability of commercial real estate companies to pay back their loans.
So how big of an issue is this for our banks? Unfortunately, neither we nor our banks know the
energy label distribution of the offices used as collateral for loans to regular corporations. For
loans to commercial real estate companies, banks know of roughly 50% of those loans what the
energy label distribution is. Of those loans where we did know the label distribution, we found
that 46% of bank loans to commercial real estate companies in relation to offices, have an energy
label lower than C. This is around 6bn worth of loans. All these loans, one could say, have
elevated credit risks, which banks, one way or the other, will need to manage. Fortunately, we are
seeing many banks react swiftly.
Banks are now demanding that any new loan or refinancing of existing loans in relation to those
offices is dependent on the client meeting the energy-label requirement on time. This should
ensure that banks will have limited exposures to offices that won't meet the deadline on time.
For us, this national legislation is a prime example of how the energy transition will lead to risks
in the financial sector.
We also looked at the risks of green finance, as I mentioned. First there is the risk of a green
bubble. History shows us that many transitions are accompanied by a boom bust cycle, whether
it's the dot-com bubble in the early 2000s, or the railway mania of the late 1900s. Whenever
there's increasing demand, a hype, or new market opportunities and instruments, there's the risk
of creating a new bubble. While we are still far away from a green bubble, institutions do tell us
that green projects have become more and more expensive, as competition has increased with
more and more institutions essentially bidding for the same projects.
A second risk we see is green washing. Do investors and consumers know what green is, when
they're buying green? There are examples of a green bond being used to make a coal plant more
sustainable. In itself, there is nothing wrong with that, or at least that's not for us to say, but what
is important is that purchasers of these bonds should be aware of this. Here, too, the work of the
European Commission on a sustainable taxonomy as well as on standards for green bonds, will be
most welcome.
Lastly, we are seeing an increased lobbying effort to lower capital requirements to stimulate
green investments. Andreas has already touched upon this, so I won't repeat that, other than that
we wholeheartedly agree: capital requirements should remain risk based. We are thus quite
skeptical of the expected plans of the European Commission in relation to prudential
requirements, even though they also acknowledge the risk based nature of capital requirements.
III. Supervision: Implications for bank risk management and supervision
So let me end with what this all means for bank risk management and supervision. The main
conclusion is that banks, including those present today, will need to manage material
climaterelated risks. And that supervisors will need to supervise this.
This is of course easier said than done. If anyone in this room already knows how to exactly
manage climate-related risks, please join us at the podium in a minute!
Two things are important to keep in mind here. One: incorporating climate risks is greatly
facilitated when governments impose clear and long term transition legislation, which
gives banks the ability to steer towards a set of well-defined goals. This is exactly what we are
seeing with the energy efficiency requirements of Dutch offices.
Two, for many parts of our economies, unfortunately there is not yet any clear legislation that
allows banks to anticipate such a set of well-defined goals. In those cases, banks would still do
well to try and gauge how their business models and which parts of their balance sheets would
be most strongly affected by the transition and which type of legislation or technological change
might be expected in those sectors. It would then be prudent to try to assess potential losses as
a result. Scenario analysis and stress testing would be a good tool for this.
Put differently, institutions will need to take a more forward looking approach to
incorporate climate related risks. This process can fortunately be helped by implementing the
recommendations of the FSB Taskforce on Climate-related Financial Disclosures. Implementing
the recommendations means you will need to explain your governance, risk management and
strategy on climate related issues. And you will need to explain which metrics and targets you use
to prepare yourself on these issues. And all of this of course means you need to have a strategy,
risk management and governance system on this issue. And that you subsequently need to have
targets and metrics to measure your progress in these areas.
Fortunately we are seeing many financial institutions in the Netherlands and abroad
experimenting with incorporating climate risk management. One Dutch bank for example, has
incorporated the energy transition into its credit policies for loans to the utility industry. This
bank will only finance utilities that have carbon reduction strategies, and the bank wants the
average energy mix of the utility companies it finances, to be in line with the 2 degree scenarios
from the International Energy Agency.
This is precisely the kind of thinking and attitude we need, to start incorporating climate risk
considerations into investment decisions.
It won't be easy, and I'm sure it won't be perfect at first either, but we need to start somewhere.
How to precisely incorporate climate-related risks into banking supervision also remains
an open question. Here too, the same two points stand out.
One, when risks are already material, we can of course already assess them. If Dutch banks for
example were ignoring the increased credit risk from the sustainability requirement for offices,
you can be sure we would be in a serious supervisory dialogue as part of the Pillar 2 credit risk
assessment. But that's of course just one very specific example, where there is specific transition
legislation affecting only a small part of our economy. It's more challenging for the energy
transition as a whole and for banks' balance sheets as a whole. How should supervisors assess
how well banks are incorporating climate-related risks there? Do we need to establish a separate
risk category in the Supervisory Review and Evaluation Process as some European Parliament
members are proposing? Or can and should we just incorporate it into the existing
SREPelements, such as for example credit risk?
We don't have all the answers yet, but we will continue to explore these questions in the years to
come, and we hope you will join us.
One thing should be clear though: sustainability factors, and climate issues in particular, can
affect the solidity of financial institutions, and therefore warrant the consideration of banks and
supervisors alike. Fortunately, just a few months ago, central banks and supervisors from 8
jurisdictions, including Germany and the Netherlands, launched the Central Banks and
Supervisors Network for Greening the Financial System. This Network aims to enhance the role
of the financial system to manage risks and to mobilize capital in the transition to an
environmentally more sustainable world. My colleague, Frank Elderson, was recently elected as
the first chair of this Network. I am grateful and excited that DNB and the Bundesbank will work
together in this Network to advance this issue in the international supervisory community.
Conclusion
Ladies and gentlemen. Today we went from mission to supervision. I hope that the transition that
DNB underwent as an organization, where relevant sustainability-considerations have been
incorporated into our core tasks, has inspired you or perhaps has even sounded familiar.
But I can also imagine that some of you might remain skeptical on the appropriateness of all this.
Perhaps some are still wondering: are we really discussing sustainability today? For those I
would like to share something my colleague Jan Sijbrand said to me recently:
"Klaas, when it comes to sustainability, we are being criticized from both sides: there are those
who say we are operating beyond the boundaries of our mandate. But there are also those who
say we are doing way too little."
"To me", he said, "That's a clear sign we're exactly on the track we should be."
And with that I would like to conclude for now.
Thank you.