Principles for Addressing Climate Systemic Risks With Capital Buffers

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Climate and environmental risks are systemic for our economies and societies. In this context, international supervisory bodies have repeatedly highlighted that climate risks are also potential systemic risks for the financial sector.1 Any systemic financial risks call for adequate macroprudential policy; climate risks are no exception to this rule. The good news is that supervisors do not need to fully recraft their macroprudential instruments to address them. With some adaptations, the toolkit developed for other systemic risks can be deployed for climate risks.

Against this background, some supervisors have started exploring and assessing the different macroprudential instruments available to address climate systemic risks.4 Systemic capital buffers emerge as one promising option among the different instruments in their toolkits.

This policy brief focuses on the potential of systemic capital buffers to address climate systemic risks. It argues that systemic capital buffers must simultaneously meet two distinctive but related objectives to address such risks adequately. First, they must ensure the robustness and resilience of the financial system when climate systemic risks materialise. Second, they must contribute to containing the buildup of these risks over time. Without the combination of these two objectives, supervisors would fall into an endless spiral in which a series of macroprudential measures continue failing at containing the buildup of systemic risks, and ever more macroprudential measures to maintain the robustness and resilience of the financial system would be required recurrently. In this context, the mitigation effect on risk buildup embedded in a macroprudential instrument is central to preventing supervisors from being trapped in such a hazardous spiral.

We propose four principles – absorption, prevention, individualisation, and recalibration – for a systemic capital buffer framework contributing to both objectives (resilience and mitigation). The combination of these principles would induce financial institutions to increase their robustness to climate systemic shocks and support their clients’ transition and adaptation efforts, thereby addressing the root cause of climate change and mitigating its systemic risks.

This note briefly reviews the links between climate risks, financial stability, and macroprudential instruments before presenting the principles systemic capital buffers should incorporate to address climate systemic risks efficiently.