Capital requirements: a “silver bullet” against the looming climate-induced financial crises

Executive summary of the report: “A silver bullet against green swans”

The climate-finance link:

The world’s leading regulators, supervisors and researchers have long recognised the link between climate change and financial stability. Financial institutions contribute to accelerating climate change by financing greenhouse gas emitting activities. In turn, they themselves are impacted by the devastating consequences of climate-related events, as well as transition measures towards a more sustainable economy. Analyses by the Intergovernmental Panel on Climate Change (IPCC) and the International Energy Agency (IEA) confirm the urgent need to reduce greenhouse gas emissions and warn of the devastating consequences of delaying action. This means that, in order to avoid a climate-related financial crisis, actions to address the risks that climate change poses to the financial system need to be taken without undue delays.

Much policy debate swirls around possible prudential policy measures to effectively address climate-related financial risks and ensure the financial sector’s resilience. Tackling the risk of “green swans” represents a particular challenge. “Green swans” are defined as disruptive climate-related events, which pose an existential threat the economy and humanity, with the dual characteristic of being certain to occur and of commanding highly unpredictable consequences. As prudential regulation for banks and insurance companies is based on three sets – or “pillars” – of rules, each holds potential to address the problem. Given the current circumstances, capital measures applied under Pillar I provide the most coherent, impactful and feasible solution – “a silver bullet” against “green swans”.

Yet, regulatory and supervisory efforts so far have been concentrated on the exploration of the scope and drivers of climate-related risks, as well as the possibilities to tackle them via “soft” prudential rules – disclosures, scenario analyses, internal risk management and governance (Pillars II and III). Significant methodological obstacles and data availability challenges remain to adequately measure and model climate-related risks. Therefore, none of the Pillar II and III measures have yet delivered tangible results to make financial institutions resilient in the wake of major climate upheavals.

Disclosures and prices – Pillar III measures:

Climate risk disclosures provide for market transparency, play a major role in market price formation and are a basis for informed finan­cing decisions. Harmonised and reliable disclosures are indispensable to direct financial flows towards sustainable projects and prevent greenwashing. However, the economic role of prices is to reflect average future expected value of assets, not their value in case of extreme events. Even accurate prices will not ensure resilience of financial institutions against climate-related events. Just disclosing risk-relevant information does not create incentives for financial market participants to change their behaviour as long as profits can be made from financing activities.

Risk management, scenario analysis and governance – Pillar II measures:

Supervisors and the financial industry are undertaking substantial work to address climate-related financial risks via risk management practices, scenario analyses (so-called “stress tests”), business stra­tegies and governance. Still, significant challenges remain to develop reliable, science-based and comparable risk identification and measurement methodologies for climate risk. Among these are data gaps and limitations of the models that simulate economic effects of climate change. Climate-related commitments – most prominently net-zero commitments – lack comparable and robust methodologies and need to be supported by clear milestones and a monitoring process. Given all this, none of the Pillar II measures have yet led to financial institutions building capital buffers for climate-related risks.

Minimum capital requirements – Pillar I measures:

Current capital rules for financial institutions do not consider climate-related financial risks, whereas capital proves the most impactful tool to address risks, as it acts as a buffer to absorb losses in crisis situations. Proposals to address climate-related financial risks via prudential capital requirements provide a feasible approach and can be implemented without further delay. Capital requirements for financing activities, which are the major contributors to climate change such as fossil fuel production, should be increased in line with their climate risk profile. This solution follows a precautionary approach and overcomes the existing data and methodological challenges to measure climate risks precisely. The approach is also coherent with the risk-based nature of prudential regulation.

Whilst each of the three prudential Pillars has its specific role to play, Pillar I is the most important to ensure the resilience of the financial sector and its ability to support the economy in the future. The financial crisis of 2008 remains a close-enough reminder. Focus on other “softer” prudential measures carries the risk of missing a critical time point for impactful action while concentrating on complacent exploration of options, which will neither be timely nor effective enough in tackling the financial stability risk induced by climate change.

Julia Symon

Read the report