Climate change has become a central topic of discussion among banking regulators and policymakers. While many policymakers focus primarily on addressing the environmental externalities associated with carbon emissions, banking regulators confront a unique set of challenges that the current regulatory framework may not fully address. In response, prudential regulators are proposing  new regulatory measures that include adjusting capital requirements and implementing additional disclosure regulations. Previous studies have explored the potential effects of introducing green capital requirements (Oehmke and Opp, 2022), but in a new paper, I focus on disclosure regulations, particularly how he disclosure of climate-related information can influence banks’ investment choices.

Around the globe, organizations responsible for setting accounting standards are introducing rules that mandate firms disclose climate-related risks. However, there is a debate over whether those disclosures should be mandatory – a particularly relevant debate for banks, given the long-standing discussions surrounding transparency within the banking sector (Zhang, 2023).

Recently, the Bank for International Settlements put forward a proposal that would require banks to disclose climate-related risks. This proposal is aligned with the objectives of Pillar 3 of the Basel III framework, which seeks to enhance market discipline by ensuring that market participants have access to a bank’s risk exposures. While the benefits of risk disclosure are widely acknowledged, the specific role of climate-related disclosures remains understudied. My goal in the paper is to analyze the interaction between climate-related disclosures, market discipline, and banks’ risk-taking behaviors.

The paper incorporates climate-related disclosures into an otherwise standard banking model of market discipline (Matutes and Vives, 1996). The model considers an economy with two banks that compete in the deposit market. At the initial stage, each bank has the opportunity to finance a project with a variable investment size, which can be interpreted as a lending opportunity. Banks have access to two distinct types of projects: green projects, which generate a relatively small negative externality, and brown projects, which generate a significantly larger negative externality. There is a trade-off between the level of externality and financial profitability, as green projects tend to yield smaller cash flows compared with their brown counterparts. In equilibrium, to alleviate competitive pressures, one bank opts to invest in a brown project (the “brown bank”), while the other bank chooses to invest in a green project (the “green bank”). Furthermore, each type of project can be either risky or safe. A bank that decides to invest in a risky brown project is exposed to climate risk, whereas a bank that invests in a safe brown project or a green project is not exposed to such risk. In practice, while green projects are less exposed to climate-related risks by nature, brown projects exhibit varying degrees of exposure. Moreover, although the probability of failure for green projects is independent of climate risk, they may still carry financial risks due to other factors.

At an interim stage, the brown bank may disclose some information to depositors regarding the climate risk associated with its project. The paper considers two different disclosure scenarios. In the first, the brown bank does not disclose any information about the climate risk of its project. Market participants are only aware of the type of project that the bank has undertaken, whether it is brown or green, but they do not have any information about the riskiness of the project. In the second scenario, the brown bank discloses the climate risk associated with its project.

Following this disclosure, each bank has the opportunity to increase the scale of its project by investing additional funds. To achieve this, the banks may choose to raise additional cash from a pool of socially responsible depositors. Each depositor decides whether to place his or her cash in the banks or to opt for the risk-free asset. All depositors are partially insured and have values-aligned preferences, meaning that they have qualms about putting  their cash in the brown bank. Depositors are also heterogeneous, as the seriousness of their misgivings varies across depositors. At the final stage, each bank’s project pays off, and the associated externalities are realized.

The paper begins by deriving the equilibrium in a benchmark case that does not involve any competition in the deposit market. In this scenario, there is only a single bank, and since climate-related disclosures provide information about the riskiness of the brown project, the focus is on the brown bank’s investment decisions. When the bank’s equity position is relatively small, the bank offers a high interest rate to depositors and chooses to invest in a risky brown project. In contrast, when the bank’s equity position is relatively large, the bank offers a low interest rate to depositors and opts to invest in a safe brown project instead.

Since depositors in the model are only partially insured, the disclosure of climate risk may provide some market discipline. This is because the interest rate that is offered by the bank becomes more closely tied to the actual risk associated with the bank’s project, but only in the presence of disclosure. This finding is consistent with the existing literature on the disciplining effect of risk disclosure (Matutes and Vives, 1996). Therefore, climate-related disclosures can ultimately lead to an increase in social welfare and a decrease in the overall size of investment in brown projects, as they can reduce the number of depositors willing to place their cash holdings in the brown bank.

The paper then proceeds to analyze the equilibrium of the main model, in which the brown bank competes with the green bank in the deposit market. In this scenario, there are two possible equilibrium outcomes. The first is the “risky brown equilibrium,” in which the brown bank selects a risky brown project, while the green bank opts for a safe green project. The second outcome is the “risky green equilibrium,” in which the brown bank decides to undertake a safe brown project, while the green bank chooses to invest in a risky green project. Interestingly, while the disclosure of climate risk may provide market discipline to the brown bank, it may also exacerbate the risk-taking problem of the green bank.

Intuitively, the disclosure of climate risk can lead to a decrease in the interest rate offered by the brown bank, as well as a decline in the number of depositors willing to place their cash in the brown bank. This, in turn, can increase the brown bank’s incentives to pursue a safe brown project rather than a risky one. In contrast, the disclosure of climate risk can result in an increase in the number of depositors who are willing to place their cash in the green bank, which can lead to an increase in the green bank’s leverage and incentives to invest in a risky green project. Therefore, the overall effect of climate-related disclosures on social welfare can be ambiguous, as it depends on the relative magnitudes of the factors involved.

The paper’s findings have  important implications for regulators. On the one hand, in the absence of competition in the deposit market, climate-related disclosures may serve to discipline brown banks from investing in risky projects, which can ultimately lead to an increase in social welfare. On the other hand, when banks compete in the deposit market, the impact of climate-related disclosures on social welfare can be more ambiguous. While the disclosure of climate risk may lead to a decrease in the leverage and riskiness of brown banks, it may also result in an increase in the leverage and riskiness of green banks, which can have offsetting effects for social welfare. Thus, the overall effect of climate-related disclosures on social welfare is ambiguous.

The paper also provides several testable empirical predictions open to further scrutiny. For instance, the results predict that the disclosure of climate risk may lead to an increase in lending to green firms, while simultaneously leading to a decrease in lending to brown firms. Another implication is that the disclosure of climate-related risk may lead to a shift of depositors from brown banks to green banks, as depositors become more aware of the climate risks associated with their investment decisions.

REFERENCES

Matutes, Carmen, and Xavier Vives. “Competition for deposits, fragility, and insurance.” Journal of Financial intermediation 5, no. 2 (1996): 184-216.

Oehmke, Martin, and Marcus M. Opp. “Green capital requirements.” Swedish House of Finance Research Paper 22-16 (2022).

Zhang, Gaoqing. “Models of Accounting Disclosure by Banking Institutions.” Foundations and Trends® in Accounting 17, no. 3–4 (2023): 173-300.

This post comes to us from Professor Lucas Mahieux at the Tilburg School of Economics and Management, Tilburg University. It is based on his recent paper, “Climate-related Disclosures, Market Discipline, and Banks’ Risk-Taking,” available here