Prudential Regulation Can Help in Tackling Climate Change

Awareness of climate-related financial risks has been growing in the past years. Prudential frameworks however still fall short in reflecting them. Given the possible impacts of climate risks on financial stability, incorporating them into prudential regulation is rapidly moving up agendas both among academics and policymakers (Campiglio et al., 2018; Volz, 2017; Monnin, 2018a). In addition, several studies have shown that current prudential regulation is biased in favor of carbon-intensive sectors. This bias enlarges the banking sector’s exposure to climate risks, thus the risk of financial instability, and at the same time hinders the substantial investments needed to transition to a low-carbon economy. This blog presents two propositions to integrate climate-related risks into macro- and microprudential regulation to both increase financial system resilience and help to fund the transition to an environmentally sustainable economy.[1]

Current regulation is not aligned with the transition to a low-carbon economy

The transition to a low-carbon economy requires considerable investments in sectors characterized by high capital costs – like, e.g., the building, industrial, transport and energy sectors. Unfortunately, the existing prudential regulatory framework hampers these investments. Indeed, a growing body of evidence suggests that the prudential schemes implemented after the financial crisis, notably with Basel III, seem to promote carbon-intensive investments at the expense of investments in low-carbon technologies (see, e.g., Liebreich and McCrone, 2013; Narbel, 2013; Spencer and Stevenson, 2013).

For example, under Pillar 1 of the Basel Standards, climate-related financial risks are narrowly defined, and regulatory capital and liquidity regulations do not explicitly require banks to assess the impact of climate-related risks on their exposures. Such a policy is equivalent to omitting one source of risk for some investments, which induces favorable funding conditions for them. As carbon-intensive investments are also the most likely to be exposed to climate risks – particularly to transition risks (see Monnin 2018b) – omitting these risks leads to a misallocation of credit at the expense of low-carbon investments.

The Net Stable Funding Ratio is another case in point: to meet this ratio banks need to use long-term funds – that are usually costlier – to finance long-term investments; this gives an incentive to banks to reduce the long-term funding which is necessary for environmentally sustainable projects. In other words, the Net Stable Funding Ratio makes banks more sensitive to temporal mismatches between investment and funding, and hence more reluctant to fund long-term environmentally sustainable investments.

Developing economies provide examples for reforms

Although the discussion about the implementation of regulatory instruments compatible with the transition to a low-carbon economy is relatively recent in high-income countries, several low- and medium-income countries have already made steps in this direction (see Dikau and Ryan-Collins, 2017). This is, for example, the case for China, India, Pakistan, Bangladesh, Vietnam, Indonesia which have all adopted mandatory prudential instruments to channel credit away from high-carbon towards low-carbon sectors. Lending limits are the instrument that is the most widely used in these countries.

Integrating environmental factors into capital requirements is a critical next step

With the exception of China where less capital is required for green than for other loans, the integration of environmental factors into capital requirements is still in its infancy. We believe this should change – both on the macroprudential as well as the microprudential level.

In our review of regulatory instruments defined under Pillar 1 of Basel III (see D’Orazio and Popoyan 2019), we find that bank capital management instruments that are used in other contexts, such as countercyclical capital buffers at the macroprudential level and capital adequacy ratios at the microprudential level, also have the potential to tame the financial instability potentially stemming from climate risks and to contribute to the transition to a low-carbon economy.

Macroprudential: Carbon Countercyclical Capital Buffer

A Carbon Countercyclical Capital Buffer (Carbon CCyB) would require banks to build up a capital buffer – i.e., a higher capital base – during periods of carbon-intensive credit growth at the aggregate level. This extra capital requirement would apply only for carbon-intensive loans and have two important impacts: first, it would reduce the bias – highlighted above – in the funding conditions of carbon-intensive investments, and thus increase financial incentives to shift capital flows in the direction of the transition to a low-carbon economy. Second, it would foster financial stability in two ways: first, by limiting banks’ carbon-intensive credit exposures in the upswing of the carbon-intensive credit cycle – i.e., acting as a “speed limit” – and, second, by building buffers ex-ante to absorb shocks to carbon-intensive loans (e.g. due to the materialization of stranded assets risks).

We believe that a Carbon CCyB would play in favor of financial stability both through its direct impact on limiting carbon-intensive credit growth and through the critical signal that financial regulators would send to financial markets. However, to be effective, an early activation of the Carbon CCyB is necessary to limit the building of excessive carbon-intensive debt and create a sufficient buffer before the materialization of climate risks.

Note that implementing a Carbon CCyB also requires an adequate calibration. Such a calibration is possible if regulators know how banks adjust their capital ratios to changes in capital requirements and how large systemic climate-related risks are. The evaluation of such risks can be based on so-called climate stress tests – like those of, e.g., Battiston et al. (2017) or Vermeulen et al. (2018). Methodologies for climate stress tests are however at their infancy, and no standard for them has crystallized yet. The pioneer stress-tests performed by the People’s Bank of China (2018) or announced by the Bank of England could serve as foundations for other regulators.

Microprudential: Brown Penalizing Factor in Capital Adequacy Ratios 

Differentiated capital requirements between carbon-intensive and low-carbon credits also have the potential to both increase the resilience of financial institutions to climate risks and to create financial incentives for the transition to a low-carbon economy. Higher capital requirements for loans to carbon-intensive activities would change the relative cost of lending for banks: it would make loans to carbon-intensive activities more expensive for them than loans to low-carbon ones. Therefore, such higher capital requirements create an incentive which is in line with the transition to a low-carbon economy because it incites banks to lend relatively more to low-carbon firms.

Differentiated capital requirements can be created either by lowering requirements for low-carbon loans or by increasing them requirements for carbon-intensive loans – i.e., by implementing a Brown-Penalizing Factor (BPF) in capital adequacy requirements. We recommend the second option (BPF) for three reasons: (1) there is no empirical evidence that low-carbon loans are less risky and thus can be awarded a discount in terms of prudential regulation (Dankert et al., 2018); (2) as current regulation does not take climate risk into account (see above), the capital requirements for carbon-intensive loans is likely to be underestimated and thus should revised upward; and (3) lower capital ratios for low-carbon loans would reduce the capitalization of the banking sector, which reduces the overall stability of the financial sector (Finance Watch, 2018).

Financial regulators: boldness, realism and a shrinking time window

A Carbon CCyB, as well as a BPF, can play an important role in increasing financial system resilience to climate risks and in supporting the transition to a low-carbon economy, by both introducing the right financial incentives and sending important policy signals. Their implementation requires on one side, an effective disclosure framework, as well as an accurate calibration; and on the other side, given the novelty of these measures, some scope for experimentation for policymakers and regulators to strike a balance between “boldness and realism”.

We should also bear in mind that, to be efficient, both instruments must be implemented before or during the building up of carbon-intensive credit imbalances. We are currently in such a phase, and the time window before the materialization of climate risks is shrinking at a fast pace. As the 2008 financial crisis reminds us, pre-emptive prudential measures must be taken before the turn of the credit cycle to avoid a too-late and too-sudden transition (European Systemic Risk Board, 2016).



Battiston, S., A. Mandel, I. Monasterolo, F. Schütze, and G. Visentin (2017). A climate stress-test of the financial system. Nature Climate Change, 7(4), 283–288.

Campiglio, E., Y. Dafermos, P. Monnin, J. Ryan-Collins, G. Schotten, and M. Tanaka (2018). Climate change challenges for central banks and financial regulators. Nature Climate Change, 8(6), 462.

Dankert, J., L. van Doorn, H. J. Reinders, O. Sleijpen (2018). A green supporting factor – the right policy? SUERF Policy Note, Issue No 43.

Dikau, S. and J. Ryan-Collins (2017). Green central banking in emerging market and developing country economies. New Economics Foundation Working Paper.

D’Orazio, P. and L. Popoyan. (2019). Fostering green investments and tackling climate-related financial risks: which role for macroprudential policies. Ecological Economics, forthcoming.

European Systemic Risk Board (2016). Too late, too sudden: transition to low-carbon economy and systemic risk. Reports of the Advisory Scientific Committee, No 6.

Finance Watch (2018). A green supporting factor would weaken banks and do little for the environment.

Liebreich, M. and A. McCrone (2013). Financial regulation – biased against clean energy and green infrastructure? Bloomberg New Energy Finance Clean Energy White Paper.

Monnin, P. (2018a). Central banks and the transition to a low-carbon economy. CEP Discussion Notes, 2018/1.

Monnin, P. (2018b). Central banks should reflect climate risks in monetary policy operations. SUERF Policy Note, Issue No 41.

Narbel, P. A. (2013). The likely impact of Basel III on a bank’s appetite for renewable energy financing. Norwegian School of Economics Working Papers, FOR 10 2013.

People’s Bank of China (2018). China Financial Stability Report 2018.

Spencer, T. and J. Stevenson (2013). EU low-carbon investment and new financial sector regulation: what impacts and what policy response. IDDRI Sciences Po, N°05/13.

Vermeulen, R., E. Schets, M. Lohuis, B. Kölbl, D.-J. Jansen and W. Heeringa (2018). An energy transition risk stress test for the financial system in the Netherlands. De Nederlandsche Bank Occasional Studies, 16-7.

Volz, U. (2017). On the role of central banks in enhancing green finance. UN Environment Inquiry Working Paper, 17/01.

[1] A more detailed analysis of these and other propositions can be found in D’Orazio and Popoyan (2019).