The Consequences of Banks Pursuing a "Double Bottom Line" as the Federal Reserve Prioritizes Climate Change Risks

 China features state owned enterprises (SOEs) that pursue a “double bottom line”.  They simultaneously seek to earn profit and to please the powerful Central Government.  Relative to their private sector counterparts, these Chinese SOE firms receive special treatment. They can often access subsidized energy, land and capital.  Facing such low factor prices such firms use more resources and this creates distortions because the opportunity cost of one firm using scarce resources is that another more productive firm does not use those resources. Macroeeconomists continue to study the implications of such misallocation for the macro-economy.

Do China’s SOEs and the resulting economic growth losses offer a preview for America’s future if the Federal Reserve’s nascent climate initiative is pursued?   This blog post sketches out the microeconomic issues.

The Federal Reserve is taking on more and more functions in the U.S economy.  Why? One reason is Congressional gridlock.  Of course the Federal Reserve has a regulatory charge that one can look up on Wikipedia but at the end of the day, the Federal Reserve is a collection of people who have skills and incentives and what interests me here is; “what do they do all day long?” “How does their agenda affect the macroeconomy, the wealth distribution and the risks posed by climate change?”

Economists are taught to think through the “counter-factual”.  What if the Federal Reserve was run by John Cochrane and there was no Climate Change Mandate?  Chairman Cochrane would likely be a vanilla Chair who would focus on committing to “rules over discretion” in order to maximize economic growth.  The Government sets clear “rules of the game” and Tom Sargent would sleep well at night.  

In such an economy,  for profit banks would focus on earning profit.  Such firms would lose profit if they make “bad loans”.  The banks would not have a “double bottom line” focus. If the CEO of such a bank wants to give her earnings to purchase carbon offsets that would be fine with John Cochrane and Milton Friedman.  Chairman Cochrane would likely commit to “no bailouts”and he might seek to educate banks about the emerging spatial and temporal distribution of risks associated with extreme heat, wildfires and natural disasters. I would hope that he would point to my writing about the emerging climate risk rating agencies and how their information could help banks to make better “bets” (more below).  

In lending other people’s money (from deposits), banks make bets about the future.  Given that assets are tied to a place, these are place based bets. In the face of ambiguous climate change, some of these bets will prove to be “bad bets”.  If Bank of America (BoA) lends me $1 million dollars to build a home in a place that subsequently floods and I then default on my loan, Bank of America has a problem.

But, this raises dynamic issues.  Why did BoA make me a fixed interest loan for 30 years?  Why didn’t it make me a 15 year loan?  Why didn’t it tie the interest rate to the location specific risk? Why didn’t BoA require me to have a lower LTV so that I have more “skin in the game”?  Why didn’t BoA co-ordinate with an insurance company to offer me a package of insurance and a loan that incentivizes me to invest in self protection so that my house faces lower risk from natural disaster?  If these microeconomic points about climate change adaptation interest you, then read my 2021 Yale Press book.

If the Federal Reserve can commit to no “bailouts” then banks actually have a greater incentive to take these actions!  Climate change adaptation is accelerated by having Chairman Cochrane in charge!    To concisely state my point, banks will internalize the consequences of climate change on their profitability if they bear the costs of not taking climate change seriously!!

One important point to note here relates to economic justice. If minority groups are physically over-represented in climate risky areas then this group’s neighborhoods will now face a higher cost of borrowing under these rules.  If Matthew is Black and if I own a home in a Black majority neighborhood that faces intense climate risk, then under the rules sketched out in this Blog post, borrowers who want to buy my house will face worse loan terms and they will bid less aggressively for my home. This lowers the resale value of my home and lowers my rate of return on housing.   This is a serious issue.  In this 2021 NBER paper, I explore the general case here.   I will return to this point in a future blog post.

To conclude this blog post, I want to hear from economists concerning what is the comparative advantage of the Federal Reserve Board in “fighting” climate change?  If for profit banks believe they can please the Biden Administration’s Fed by appearing to take the climate change seriously, then they become a type of Chinese SOE and the issue of the misallocation of capital arises.  As banks become more political who gets capital and who doesn’t?  

In a series of papers, I have argued that the best strategy to reduce the impact of climate change on the poor and on our nation is to pursue economic growth.  A richer people and a richer nation is better able to withstand the harder punches that Mother Nature is throwing at us.