20 October 2021

The world’s central bankers have been worrying about green swans lately. The Bank for International Settlements (aka BIS), which is the central bankers’ central bank, even held a “Green Swan” conference. What does this mean for Australia’s banks?

Since the GFC, central bankers have been regularly subjecting the banks they regulate to stress tests. These stress tests are designed to uncover weaknesses in the banks’ balance sheets and operating procedures where a “black swan” event might trigger a bank collapse or even another systemic crisis. In the last two years, central bankers have come to realize that climate change creates very large risks for banks’ loan books. These new types of risk are called “green swans”.

The most obvious risk is the effect of rising sea levels on coastal cities. East Asia will be the worst affected, because densely populated coastal cities account for more than half of the region’s economic activity – think Tokyo, Osaka, Seoul, Tianjin, Shanghai, Hong Kong, Shenzhen, Guangzhou, Singapore. A 2020 China Water Risk report looked at 20 Asian coastal cities and forecast that the best outcome was that 28 million people, half of the coastal airports, and almost all of the ports would be under water by 2030. Given the real estate purchasing patterns of such luminaries as former Prime Minister Rudd, one could be forgiven for expecting that Australia will be immune to rising sea levels. Observing politicians’ obvious brilliance in all things – including climate change impacts to the planet and the economy and not necessarily in that order – surely the incredibly climate conscious K-Rudd would never have purchased a property in Noosa if his manifold scientific knowledge of rising sea levels was incorrect.

Readers who are familiar with the Atlantic and Gulf Coasts of the US will know that this coastline is low-lying, either sandy or marshy (*polite cough* like Noosa), so most of the towns there already have a long and painful history of flooding and storm surges. Federal and State governments have started making buy-out offers to homeowners in the worst-affected areas, because every cyclone or flood saddles the authorities with huge costs to handle the emergency, even before they start repairing the damage.

For historical reasons, the eastern seaboard of the US is dotted with major population centres. Only some 15% of homes in coastal areas are covered by flood insurance, partly because it is expensive, and partly because the insurer is allowed to walk away at each annual renewal. The mortgage lender is of course stuck with the risk for the whole life of the loan.

Consider the recent history of Houston, New York and Miami. In 2017, Cyclone Harvey dumped one metre of water on south-eastern Texas in the space of four days, causing more than USD$125 billion of damage. Superstorm Sandy in 2012 only caused USD$65 billion of damage, but it was a major wake-up call for New York and New Jersey residents who did not understand just how vulnerable they were. Miami, like the rest of Florida, is used to hurricanes and floods, but they have become more frequent and more damaging: what used to be called “100-year floods” are now occurring once or twice a decade.

The West Coast is less prone to storms and floods, but its high property values mean that rising sea levels will be very expensive. In California alone, a 2020 study by William Yu for UCLA Anderson Forecast estimated that a four foot (1.2 metres) rise in sea level would affect 66,600 homes and cause USD$68 billion of property losses.

Then there is the risk of drought. Prolonged or repeated droughts damage the viability of local agriculture and industry, and eventually the losses to local economies will lead to business closures, job losses, mortgage defaults and out-migration. (Remember the long-term decline of Detroit as the US auto industry encountered the problems of competing imports and new factories in the South.) This year, residents in the US Southwest suffered their worst drought and heatwave since records have been kept, because the winter snowpack was far below average and dam levels were already very low.

Against loan losses of this magnitude, the banks’ exposure to fossil-fuel industries pales into insignificance. How many bankers will have time to worry about their bad loans to oil companies, when a quarter of their home loan book is under water? (Literally.)

France’s central bank has already run the world’s first green stress tests. In May, the Banque de France looked at the risk exposures of its banks and insurers over the next thirty years. No penalties were imposed – the exercise was intended to encourage banks to incorporate climate risks into their standard risk management frameworks. Central banks in other countries will soon follow suit.

For Australia’s Big Four banks, climate change is an additional challenge on a plate already heaped high with challenges, namely:

  • Fintech start-ups
  • Neobanks with cloud-based IT (no legacy systems)
  • Open banking
  • Faster payment systems
  • Central bank digital currencies.

The biggest problem currently facing the Big Four is an absence of organic growth. We continue to believe that, although the banks will track Australia’s post-coronavirus recovery, they will underperform the market in the longer term. In the short term, however, the banks are likely to announce share buybacks or special dividends. Therefore we recommend that investors re-assess their bank holdings very cautiously in the next results season.

 

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