ASC Insight: Bank capital regulation and climate change

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Climate change has become a major topic of discussion at central banks and financial regulators. Key aspects of this debate include whether and how monetary policy and financial regulation should take climate change and the associated risks into account.

This note focuses on the bank capital regulation aspect of the debate. Climate change is relevant for bank regulators along two potential dimensions. First, climate change may expose the banking sector to financial risks that the current regulatory framework does not account for. In particular, prudential capital requirements based on historical default frequencies are unlikely to fully account for future physical and transition risks arising from climate change. Second, bank capital regulation has been proposed as a tool for tackling the consequences of climate change more broadly by supporting the transition to a low-carbon economy (see, for example, Dombrovskis, 2017), so long as no global carbon tax has been implemented.

Based on recent academic research (Oehmke and Opp, 2022), Section 1 of this note describes a conceptual framework for assessing the introduction of differentiated capital requirements for “clean” and “dirty” loans. Building on this framework, Section 2 discusses bank capital regulation in the presence of climate risks and carbon externalities, and Section 2.1 presents a categorisation of climate risks for financial regulators based on cause and effect. Section 2.2 discusses capital requirements as a regulatory tool for addressing climate-related prudential risks. Section 2.3 assesses capital regulation as a regulatory tool for reducing carbon emissions and associated externalities.

This note concludes that bank capital requirements can be an effective tool for dealing with prudential risks arising from climate change. Conceptually, addressing these risks through bank capital regulation is no different to dealing with traditional financial risks. The main difficulty is the measurement of climate risks, given that historical data series contain limited information on the nature of these risks. Despite recent progress – for example, relating to climate stress tests – measuring climate risks poses a significant challenge for regulators.

In contrast, bank capital requirements are likely not the most effective tool for reducing carbon emissions. As long as carbon-intensive activities remain profitable, using capital requirements to induce banks not to finance these activities may be impossible or may involve sacrificing financial stability. In addition, even if capital regulation deters banks from funding such activities, firms may turn to bond markets, private equity investors or internally generated funds. More direct policy measures, such as carbon taxes, are more effective when the goal is to reduce emissions and the associated externalities, as opposed to when the goal is to ensure that the banking system can withstand prudential risks resulting from climate change. While capital requirements alone are not an effective tool for reducing carbon emissions, they can play a supporting role by facilitating more direct policy measures. In particular, in the absence of a sufficient equity cushion in the banking sector, governments may be reluctant to impose carbon taxes for fear of triggering a banking crisis.

Published on the website of the ESRB