Why Latin America’s Financial Regulatory Policy Needs to Include Climate and Social Risks

By Luma Ramos

Latin America has been severely impacted by the COVID-19 pandemic. As one of the most affected regions in the world in terms of infections, it also has been the most economically distressed region, with an estimated GDP contraction of approximately 7.7 percent in 2020. Recovering from this crisis will require Latin American countries to implement policies that help them face structural bottlenecks and the ever-growing threat of socio-environmental conflicts, climate emergencies, and long-term climate change.

A working group of experts, including Latin American bank regulators, development bankers and related experts, recently convened to review the policy toolbox available to financial regulators and map a way forward. These results were published in a May 2021 report ‘Green Financial Regulatory Policy for Latin America in the Aftermath of COVID-19.’

On May 6, the Boston University Global Development Policy Center and the International Network for Sustainable Financial Policy Insights, Research and Exchange (INSPIRE) hosted a webinar to launch a new report on “greening” financial regulatory policy for Latin America. The event was moderated by Natasha Kunesch, a researcher at INSPIRE, and Nick Robins, INSPIRE co-chair and professor at the Grantham Research Institute on Climate Change and the Environment, London School of Economics and Political Science. The panelists included Daniel M. Schydlowsky, GDP Center Distinguished Scholar, Mariana Escobar Uribe, Advisor to the Financial Superintendent of Colombia, and Pascual O’Dogherty, Secretary-General of Association of Supervisors of Banks of the Americas.

The event aimed to address how Latin America can best recover from the COVID-19 pandemic and address systemic climate weaknesses in their financial regulatory sectors. The panelists also discussed how regional financial institutions can incorporate climate risk elements into their work and what tools are available to financial institutions to internalize externalities in a post-COVID world.

Mr. Schydlowsky opened the discussion highlighting the working group’s main findings and recommendations, stressing that Latin America’s underlying challenges of socio-environmental conflicts, climate emergencies, and long-term climate change were aggravated by the pandemic. He argued the region’s financial regulators must adjust to the new circumstances and deal with the COVID-19 outbreak and climate risks at the same time.

He emphasized two current economic specificities: i) the awareness of externalities and that their behavior has consequences for all those with whom they interact, and ii) the reality of the existence of externalities, as evidenced clearly in the supply and payment chains. In this context, financial regulation must internalize the interdependencies in the financial system, applying compulsory Environmental and Social Risk Management (ESRM) instruments. ESRM is an assessment tool and can be used in an internal capacity at financial institutions to identify and manage environmental and social risks as part of the risk appraisal process for financial operation. Then, create a strategy to prevent, mitigate or contain such risks and thereby reduce them. Briefly, ESRM examples are i) comprehensive description of the project to be financed: identification of its area of influence and the relevant economic, social, and environmental conditions present therein; ii) environmental regulations applicable to the project; and iii) evaluation of potential socio-economic and socio-environmental impacts.

Mr. Schydlowsky supported ESRM as the core instrument to bring the externality into the day-to-day functioning of the financial system. Summarizing the working group’s recommendation, he argued state-owned development banks should lead the implementation of the ESRM tools. He concluded that finance is everywhere, just like climate, and financial regulation is a powerful lever that should be used to set up desired change.

Following this, Ms. Escobar Uribe stressed that the current moment requires an alignment between private and public interests. The private sector must integrate social values in its actions and do so by internalizing the externalities systematically and efficiently.

As a mandatory requirement, she mentioned that financial companies and supervision entities must have the correct tools and be aware and confident that these instruments are essential to mitigate risks. Additionally, she argued that the private sector should incorporate and face climate change and social conflicts as threats to its own business.

Next, Mr. O’Dogherty underlined that the climate change agenda requires international cooperation and coordination. As a public good, climate hazards impact the entire world, not just high-emission nations. Isolated measures might be inefficient and may lead to carbon “leakages.”

Mr. O’Dogherty also argued for particular benefits to emergent economies. As these countries have fewer economic and technological resources, they face more problems implementing adaptation and mitigation measures. Any coordinated regional action must include an awareness of the idiosyncrasies of poorer economies.

Mr. Robins’ then pointed out that the COVID-19 crisis might actually work as an accelerator to macroprudential regulation, highlighting that there is an opportunity to transition away from fossil fuels and to integrate environmental and social risks in the prudential policy toolkit.

During the question and answer sessions, the panelists addressed queries regarding the strategic role of the Biden-Harris administration in leading a climate agenda in Latin America and the Caribbean; the need for a homogeneous and compatible regulatory framework in the region and the challenges associated with it; and the urgency to coordinate and align Latin American actions and ESRM measures, improve dialogue between actors, exchange and share best practices and ideas.

COVID-19 has exposed Latin America’s structural bottlenecks and deepened its existing challenges. This calls for updating the region’s regulatory policy frameworks. The core quality of these frameworks is their ability to internalize the myriad externalities found in present economic conditions. In other words, the system must ensure financial agents are taking into account not only the direct effects of their actions but also the indirect ones.

Updating these frameworks is critical to assuring a long-term robust financial system and the evolution of the economy along a path that is in accord with environmental and climate change requirements.