The Role of Central Banks in Green Development

The role of Central Banks in the fight against climate change has been in the forefront of discussion in recent days. Representatives on both sides of the debate ponder the extent to which the government’s leading monetary tool should concern itself with addressing this ever-growing problem. I argue that Central Banks, as institutions of public policy, should play a key role in fostering green development because of their power to intervene in the market; namely affecting resource allocation through policy implementation.

This argument is built on the notion that purely market-based processes do not offer adequate support to green development, because market-based actors operate around maximising profits with little regard for social welfare, and that the corresponding lack of profitability in green development projects demonstrates the lack of incentive in the free market. This thus necessitates Central Bank intervention, in this case in the form of resource allocation policies, to ensure that the adequate resources are diverted within the market to projects necessary for climate change adaptation.

Central Banks are at the apex of the financial system. They have the prerogative of money creation, provide loans to commercial banks, and control monetary policy. Because ‘governments are the beneficial owners of central banks’, they have traditionally been used as part of a ‘policy apparatus’ to guide and finance nation-wide development projects. In this respect, the political connection between Central Banks and the government determines the policies that Central Banks implement. Applied against the backdrop of climate change, it is clear that in order to transition into green development, carbon-intensive sectors need to reduce, and ideally halt, their polluting activities.

It has been argued, therefore, that there is a failure within the credit market that arises due to the mismatch between pursuit of private interest (by the free market), and the objective of societal welfare (by the government and Central Bank). Central Banks have the capacity to ameliorate this credit market failure by using credit allocation policy instruments to divert lending away from industries that are high-polluting, and direct credit instead towards green projects. This is a characteristic feature of theirs because of their position as a lending facility in the financial system.

The most common way, traditionally, to control credit allocation is subsidised loan rates. This entails the Central Bank subsidising loan rates for priority sectors, which applied to green development, would provide incentives for commercial banks to supply credit to environmentally friendly sectors at lower loan rates, in turn allowing the commercial banks to use rediscount bills at lower rates. Central Banks are able to do this because they lack the typical financial constraints that market-based actors face, as they have the capacity to issue money and therefore obtain assets. They are thus endowed with ‘financial strength’; unparalleled buffers and reserves, deriving from their relationship with the government, that allow them the necessary funds to intervene in markets. As such, they need not privilege profitability to remain functional and have the resources to invest in subsidisation schemes that will only be profitable to them in terms of social welfare. Hence, Central Banks are distinct in their capacity to foster green development as their unique reserves and position as government tools allow them to intervene in markets and try to minimise the negative externalities (pollution) arising from them.

An example of such was carried out by the Bangladesh Central Bank, a traditionally more interventionist institution, in cooperation with other governmental entities. It refers to itself as the first central bank globally to have taken real initiatives to champion Green Banking. In 2009, the Bangladesh Bank designated US$25 million to subsidise loan rates to commercial banks disbursing loans to six specific products, including investment in solar energy, waste-treatment projects and biogas funding. As well as implementing refinancing lines at preferential terms for projects devoted to climate change adaptation, the Central Bank has ordered that all financial actors (commercial banks and non-bank financial institutions) must devote 5% of total investment into green sectors.

This is also a type of credit allocation policy, that the Central Bank is able to enforce due to their authority as a government tool. Their efforts are proving commendable, as analyses of their credit policies show that over the past few years, both the project categories and the funds dedicated have greatly grown over time, and are thoroughly implemented by financial and governmental authorities; out of 56 banks in total, 45 had created policies for green banking.

Being one of the countries most heavily impacted by climate change, the Bangladesh Central Bank’s resource allocation policies are ahead of the rest of the world’s, providing us with an example of what required investments will need to be undertaken as the threat of climate change grows larger. I have attempted to use this an example to communicate how Central Banks can, and should take a leading role in fostering green development because of their role as government tools and subsequent ability to intervene in markets.