Banks do best for society when they have more capital, not less

On 24 January, EU policymakers demonstrated that when it comes to financial stability, memory is short. Members of the European Parliament Committee on Economic and Monetary Affairs assembled in Brussels to vote on amendments to the Capital Requirements Regulation and Capital Requirements Directive. It was an opportunity to update EU rules put in place after the global financial crisis to properly address the risks facing banks.

Sadly, it was an opportunity wasted. First, the agreed rules deviate significantly from Basel III, the internationally agreed regulatory framework for banks. They disregard calls of banking supervisors, including the ECB, for the faithful implementation of the Basel reforms. Second, the approved rules do not go far enough to address climate-related financial risks.

Climate science is very clear on the fact that exploring new fossil fuel reserves is incompatible with global climate commitments. The sustainable transition will mean enormous loss of value in the fossil fuel industry and losses for banks that finance fossil fuels. If “business as usual” continues, climate change will wipe out tens of trillions of dollars from our economy via more frequent and extreme climate events, and banks are intricately exposed. Thus, the continued financing of the fossil fuel industry will inevitably result in massive losses for the giants of finance, which have the potential to trigger a financial and economic crisis.

Today, investment in and financing of the fossil fuel industry is still treated as any other type of corporate financing from the risk and capital perspective, which means that banks’ capital buffers will prove largely insufficient to cover the losses looming on the horizon.

Ahead of the ECON committee vote a solution was put on the table – the one-for-one rule. The one-for-one rule means that the financing of new fossil fuels should be done exclusively out of the banks own funds, without leveraging depositors´ money. It would see a 1250% credit risk weight applied to the financing of new fossil fuel projects.

Unfortunately, MEPs did not vote for the one-for-one rule that January morning in Brussels. Given that on the same day – in the same room – the same people agreed to increase capital requirements for crypto assets, leaving many puzzled.

Would it have been too big a burden for banks? No. Banks with a robust risk management framework and credible net zero pledges – that have recognised financing new fossil fuel exploration is incompatible with any net-zero transition pathways – would not be affected by the one-for-one rule. Rather, it would be a safeguard against reckless risk-taking and provide protection for citizens and taxpayers against a climate-driven financial crisis and a new possible wave of bank bailouts.

Were the other ESG measures voted through sufficient? No. While mandatory transition plans and targets are a step in the right direction, without capital requirements fixed in the regulation, climate-related financial risk will continue to threaten our financial system. If we’ve learned anything from the past, it’s that a bank with insufficient capital can easily go bust if it suffers large losses.

Prudential regulation can no longer ignore the impact of climate change on financial stability.  This is not about punishment, politics or finger pointing. It’s about ensuring the resilience of the financial sector and its ability to support the economy in the future.

Julia Symon