By Matthew Razzano*Law Clerk. J.D., Notre Dame Law School, 2019; M.Sc., London School of Economics, 2016; B.A., University of Notre Dame, 2012.
Twenty years ago, a deputy governor of the Bank of England (“BOE”) remarked that “a successful central bank should be boring.”1Mervyn King, Deputy Governor, Bank of Eng., Monetary Policy: Theory in Practice 6 (Jan. 7, 2000), transcript available at https://perma.cc/4DK9-MRJU. Yet in an age of globalization and interconnectedness, successful central banks must look beyond their historical mandates and consider everything from instant payment systems,2See Victoria Guida, Big Banks Prepare to Battle Fed on Faster Payments, Politico (July 19, 2019), https://perma.cc/SN5P-ZHNF. to digital currency,3See Phillip Inman, Bank of England to Consider Adopting Cryptocurrency, Guardian (Jan. 21, 2020), https://perma.cc/RSK8-MX97. to global warming. Central banks around the world have started to recognize the danger climate change poses to financial markets—from insurance payments tied to extreme weather events to the business costs of transitioning to a green economy.4Gregg Gelzinis & Graham Steele, Climate Change Threatens the Stability of the Financial System, Ctr. Am. Progress (Nov. 21, 2019), https://perma.cc/YXJ3-J8VW. Following this trend, the Federal Reserve (“Fed”) has started to consider climate data in its financial models.5Jeanna Smialek, Why the Fed, Long Reticent, Has Started to Talk About Climate Change, N.Y. Times (Nov. 8, 2019), https://perma.cc/3A8T-HD97. The Fed should also use its broad legal mandate to respond to environmental crises and proactively stimulate green investment. A successful Fed in the coming years must be anything but boring.
Only recently have central banks started acknowledging the connection between environmental issues and financial markets. The BOE was one of the first central banks to act.6See Mark Carney, Governor, Bank of Eng., Breaking the Tragedy of the Horizon – Climate Change and Financial Stability, Speech before Lloyd’s of London (Sept. 29, 2015) [hereinafter Carney Lloyd’s Speech], transcript available at https://perma.cc/MX66-JXGB; see also Mark Carney, Governor, Bank of Eng., A New Horizon, Speech before European Commission Conference (Mar. 21, 2019), transcript available at https://perma.cc/RN7P-3JEN. In 2019, it launched a novel initiative, becoming “the first regulator to stress test its financial system against different climate pathways.”7Mark Carney, Governor, Bank of Eng., Remarks Given During the UN Secretary General’s Climate Action Summit 2019, at 3 (Sept. 23, 2019), transcript available at https://perma.cc/H2KB-K9LN. In addition, the Bank’s Governor, Mark Carney, pushed for banks to provide additional climate-based disclosures and reporting.8See id. at 8. Green disclosures are additional information companies must provide, so that regulators and investors better understand their environmental impact or footprint. See id. at 8–10. The BOE stated that its “aim is to make sure that individual banks and insurers consider the financial risks that can arise from climate change, as they would for other kinds of risks.”9Climate Change: Why it Matters to the Bank of England, Bank of Eng., https://perma.cc/QL5H-Q9UF. Similarly, the European Central Bank (“ECB”) has also started to incorporate climate data into their models to better assess financial impact.10See Climate Change and the ECB, Eur. Cent. Bank, https://perma.cc/7UV4-SBLM. “Climate data” in this context measures how climate change interacts with financial systems. It includes pressures on insurance programs from more frequent and intense disasters, the influence of ESG matters in investor decisions, and budgetary concerns related to the transition to renewable energy. Modeling behavior on this data gives central banks an idea of how actors will respond to climate pressures, enabling more effective management of the financial system in the face of such pressures. Executive Board member Yves Mersch said that while central bankers must remain independent, “monitoring and [analyzing] the extent to which climate change or other shocks may affect the transmission of monetary policy, the economic cycle, the soundness of individual banks and financial stability as a whole, and how they interact, is part of [the ECB’s] forward-looking approach.”11Yves Mersch, Member of the Exec. Bd., Eur. Cent. Bank, Climate Change and Central Banking, Remarks at Workshop Discussion: Sustainability is Becoming Mainstream (Nov. 27, 2018), transcript available at https://perma.cc/GFD7-4RTG. Even the People’s Bank of China (“PBC”) has started to look at financial markets with a climate lens. The PBC stated it “will focus on analyzing the influence on different parts of the financial sector and how policy makers should subsequently respond. The bank will also conduct a feasibility study on factoring in the impact into its macro-prudential framework.”12Yinan Zhao, China Central Bank to Study Impact of Climate Change on Financial Sector, Bloomberg (Dec. 22, 2019), https://perma.cc/BFF8-V7G8.
In November 2019, the Fed announced that it too would start considering the impact of the environment on the economy. It hosted The Economics of Climate Change Conference in San Francisco as a launching pad to promote green initiatives.13See The Economics of Climate Change, Fed. Res. Bank S.F. (Nov. 8, 2019), https://perma.cc/C98N-5YTS.In her opening speech, Mary C. Daly, President of the San Francisco Fed, remarked that accepting climate change’s financial impact is “essential to achieving our mission”14Mary C. Daly, President, Fed. Reserve Bank of S.F., Why Climate Change Matters to Us, Remarks at The Economics of Climate Change Conference 1 (Nov. 8, 2019), transcript available at https://perma.cc/B5GS-FJCZ. and that “climate change is an economic issue we can’t afford to ignore.”15Id. at 4. Later, Board of Governors member Lael Brainard claimed that the Fed needed to “study the implications of climate change for the economy and the financial system and to adapt our work accordingly.”16Lael Brainard, Member, Bd. of Governors, Fed. Reserve Sys., Why Climate Change Matters for Monetary Policy and Financial Stability 2 (Nov. 8, 2019), transcript available at https://perma.cc/5LQ5-RFZT.
The Fed already has the legal capacity to adapt to changing economic conditions through its macroprudential role of overseeing financial markets. While the Fed is primarily known for conducting “the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates,”17Bd. of Governors of the Fed. Reserve Sys., The Federal Reserve System: Purposes & Functions 1 (10th ed., 2016), https://perma.cc/7VWW-MMES. it has regulatory powers that extend beyond this narrow directive. The Fed is responsible for monitoring individual financial institutions and assessing “risk-management systems, financial condition, and compliance with applicable laws and regulations.”18Id. at 83. This gives the Fed flexibility to evaluate any information relevant to risk-management, and involves “establishing the rules within which financial institutions must operate—in other words, issuing specific regulations and guidelines governing the formation, operations, activities, and acquisitions of financial institutions.”19Id. at 74. Through these general powers of financial oversight, the Fed can collect all inputs affecting markets—including environmental factors. Below are three ideas—and their legal bases—that would allow the Fed to promote a strong environmental agenda.
Data Collection and Risk Disclosure
Before the Fed can adopt policy to address climate change, it should specifically incorporate environmental data into its economic models to better grasp the effect on financial markets. Although this would not directly mitigate climate change, it would help foster a shift in attitude. Daly and Brainard both stated in their climate speeches that the Fed will consider climate data when it evaluates banks, or sets interest rates, or assesses market stability.20See Brainard, supra note 16, at 7–10; Daly, supra note 14, at 2–4. Legally, the Fed is not limited in what data sources it draws from to make its decisions. For instance, it has the authority to “examine at its discretion the accounts, books, and affairs of each Federal reserve bank and of each member bank and to require such statements and reports as it may deem necessary.”2112 USC § 248(a)(1) (2018) (emphasis added). And with open market operations, the Fed has “the power to establish from time to time, subject to review and determination of the Board of Governors of the Federal Reserve System, rates of discount to be charged by the Federal reserve bank.”22Id. § 357. Neither provision specifically enumerates what information the Fed can consider, but “may deem necessary” implies a broad pool of data that could include climate information.
With no apparent restrictions on the type, mediums, or data formats gathered, the Fed could require additional environmental disclosures, but it should only do so if it coordinates with other agencies to avoid overlapping regulation. In the name of investor protection, the Securities and Exchange Commission (“SEC”) wields similar authority to require environmental disclosures from public companies. Specifically, “the Commission may issue rules designating documents or information that shall be provided by a broker or dealer to a retail investor before the purchase of an investment product or service by the retail investor.”2315 U.S.C. § 78o(n)(1). The SEC “consider[s] whether the rules will promote investor protection, efficiency, competition, and capital formation.”24Id. § 78o(n)(2). As a result, the SEC likely possesses much of the environmental information the Fed might seek. Added disclosures and red tape tend to drive expenses higher, which in turn increases the cost of lending.25Sean M. Hoskins & Marc Labonte, Cong. Research Serv., R43999, An Analysis of the Regulatory Burden on Small Banks 1 (2015), https://perma.cc/7NRG-WXK6. Thus, inter-agency coordination is key if the Fed is going to require more from banks under its purview.26Granted, the SEC’s disclosure requirements would apply to large publicly-traded banks, but not private ones. Nevertheless, the financial impact would be greatest among these larger financial institutions. The Fed would have to pursue other regulatory avenues to collect information from smaller banks. Nevertheless, environmental data collection and incorporation are easy first steps and well within the ambit of the Fed’s legal authority.
Climate-Based Banking Stress Tests
The second initiative that the Fed should consider is climate-based stress tests. Part of the Dodd-Frank framework involved normalizing these simulations.2712 U.S.C. § 5365(a), (d)(1)(A) (“[T]o prevent or mitigate risks to the [United States’] financial stability… the Board of Governors shall… establish prudential standards… includ[ing] risk-based capital requirements….”). Their purpose is to prepare banks for future financial or geo-political crises.28See Donald Kohn & Nellie Liang, Understanding the Effects of Bank Stress Tests: A Q&A, Brookings Inst. (July 8, 2019), https://perma.cc/7FBN-ET69. Most central banks started performing stress tests after 2008, with some foreign banks controlling for environmental risks.29See Bank of Eng., 2021 Biennial Exploratory Scenario on the Financial Risks From Climate Change (Dec. 2019), https://perma.cc/5V39-5KWS. For example, the BOE announced in late 2019 that it would incorporate climate data into its stress tests.30Press Release, Bank of Eng., Bank of England Consults on its Proposals for Stress Testing the Financial Implications of Climate Change (Dec. 18, 2019), https://perma.cc/6ACC-8YHP. The ECB is also considering a similar move.31Jill Ward, ECB Considering Stress-Testing for Climate Risks, Guindos Says, Bloomberg (Nov. 14, 2019), https://perma.cc/42D7-37G9.
Climate-based stress tests go beyond mere data collection; they are simulations. They model risks in real time to see how banks respond.32Kieran Dent, Ben Westwood, & Miguel Segoviano, Stress Testing of Banks: An Introduction, 56 Bank of Eng. Q. Bull. 130, 131 (2016), https://perma.cc/6EZW-BKZY (describing how concurrent stress tests help policymakers identify financial risks based on how stressors influence the behavior of, and interactions between, multiple banks encountering the same financial shocks). This provides the Fed with invaluable information, and helps financial institutions manage risks on their own by uncovering internal vulnerabilities to market instability. Environmental issues are not necessarily top of mind for most financial institutions, so the introduction of climate-based stress tests could better prepare firms for the coming challenges and spur positive behavior to counteract the deleterious effects of climate change.
The Fed already stress tests financial institutions, but can it prod for climate risks? Currently, the Fed “shall conduct annual analyses in which nonbank financial companies supervised by the Board of Governors and bank holding companies . . . are subject to evaluation of whether such companies have the capital, on a total consolidated basis, necessary to absorb losses as a result of adverse economic conditions.”3312 U.S.C. § 5365(i)(1)(A) (2018) (emphasis added). The last phrase gives the Fed authority to test a variety of adverse conditions. While this obviously includes financial-specific risks, it should legally allow for climate-based testing because climate change can create adverse conditions. For example, increased insurance claims from extreme weather demonstrate a direct link between climate change and economic conditions.34Nat’l Ass’n Ins. Comm’rs., The Potential Impact of Climate Change on Insurance Regulation (2008), https://perma.cc/4XBZ-Q6KX. The statute also posits that the Fed “may develop and apply such other analytic techniques as are necessary to identify, measure, and monitor risks to the financial stability of the United States.”3512 U.S.C. § 5365(i)(1)(B)(iii). Together, these provisions give the Fed leeway to test all necessary risk factors—including those arising from climate change— to see how banks respond.
Green Quantitative Easing
Finally, after the financial crisis, central banks engaged in quantitative easing (“QE”). Banks purchased government debt and other securities directly, which acted as a sort of economic steroid injection.36See Robert B. Ahdieh, From Fedspeak to Forward Guidance: Regulatory Dimensions of Central Bank Communications, 50 Ga. L. Rev. 213, 215 (2015). These programs were divisive because the Fed intervened more extensively than it had in the past, and winding down these heavy capital infusions proved difficult.37Cf. Nick Timiraos, The Fed is Buying Treasurys Again. Just Don’t Call it Quantitative Easing, Wall St. J. (Oct. 16, 2019), https://perma.cc/3WFQ-DYQT (describing how the Fed continues to buy securities “simply to keep up with currency growth” after two rounds of QE in 2008 and 2014). Yet some central banks have considered addressing climate change through so-called Green QE.38Sini Matikainen, Emanuele Campiglio, & Dimitri Zenghelis, Ctr. for Climate Change Econ. & Pol’y, The Climate Impact of Quantitative Easing 1–2 (2017), https://perma.cc/NY8C-FDKP. This differs from traditional QE because—instead of only purchasing government-issued bonds—central banks either negatively screen “brown” (environmentally unfriendly) securities or positively screen for “green” (environmentally friendly) securities when purchasing them.39The Rights and Wrongs of Central-Bank Greenery, Economist (Dec. 14, 2019), https://perma.cc/FVZ4-4AYT. This way, the central bank fosters the transition to a greener economy by directly injecting capital into green initiatives without supporting environmentally-harmful operations.40See id.
In the United States, the Fed has historically only purchased government debt—not stocks or corporate bonds.41But see Press Release, Fed. Reserve, Federal Reserve Announces New Measures to Support the Economy (Mar. 23, 2020), https://perma.cc/2JU6-D8ET. In the wake of the coronavirus, the Fed has made unprecedented moves to stabilize the economy, which includes purchasing corporate debt for the first time in its history. It is unclear whether this decision will normalize the purchase of non-governmental securities, or whether this move will ultimately get challenged in court. The Federal Reserve Act states that the Fed may buy “obligations of National, State, and municipal governments; open market operations; purchases and sales from or to United States; maximum aggregate amount of obligations acquired directly from or loaned directly to United States.”4212 U.S.C. § 355 (2018). This suggests that the bank may only acquire directly-issued government debt.43Additionally, the expressio unius canon “instructs that the inclusion of one statutory term implies the intentional exclusion of another.” Anita S. Krishnakumar & Victoria F. Nourse, The Canon Wars, 97 Tex. L. Rev. 163, 187 (2018). The absence of specificity, however, might suggest that the Fed has room to purchase other securities. If that’s true, then there is no question that the Fed could initiate a round of Green QE to stimulate environmental investment. But without clear statutory language, it is likely that such a decision would face fierce court challenges and added politicization, damaging the Fed’s historically independent position.
Yet the legal capacity to initiate a round of Green QE already exists—albeit in a roundabout fashion. First, the Fed would need to coordinate with other agencies. The United States Treasury would issue “green bonds”44John Chiang, Milken Inst., Growing the U.S. Green Bond Market Volume 2: Actionable Strategies and Solutions 2–6 (2018), https://perma.cc/4K9U-KTGL.—debt earmarked for climate-related projects.45See id. For instance, if a large company wants to install solar panels, it may issue bonds to support the project, and the associated debt could be classified as “green.” The same process applies when the government wants to issue debt. The federal government could issue green bonds for government-sponsored environmental projects. Then, since this green debt is now state-sponsored, no legal roadblock would prevent the Fed from purchasing those securities.
Still, QE remains controversial, and Green QE would be even more politically trying.46Green QE Would Seriously Distort Markets—ECB’s Villeroy, Reuters: Bond News (Sept. 17, 2019), https://perma.cc/WX6K-5HXN. But the Fed, like most other central banks, now agrees that climate change will destabilize financial markets.47See, e.g., Daly, supra note 14; Carney Lloyd’s Speech, supra note 6. As such, drastic steps might be needed to prevent this impending threat. Green QE might be bold, but it would demonstrate the Fed’s commitment to environmental protection and signal a strong step forward in counteracting climate threats.
Despite having the legal authority to pursue a new climate agenda, critics might worry that the Fed’s authority is too expansive, or that it should narrow its focus. But the Fed now faces an economy so complex that it requires a wider outlook. Robert F. Kennedy famously remarked that “the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. . . . [I]t measures everything in short, except that which makes life worthwhile.”48Senator Robert F. Kennedy, Remarks at the University of Kansas (Mar. 18, 1968), transcript available at https://perma.cc/6VHY-G9WJ. The modern Fed has taken these words to heart. Traditional financial metrics might not incorporate climate data, but today, the Fed views climate change as inextricably linked to markets. What’s more, the Fed has the legal authority to promote an aggressive climate agenda that includes environmental tailoring of financial models, climate-based stress testing, and green quantitative easing. The ideas presented in this blog post are by no means comprehensive, but they at least illustrate that today’s institutions have the legal flexibility to respond to challenges that they may have not been designed to address.