ECB examines climate-related capital requirements

The European Central Bank (ECB) is examining a climate risk buffer requirement and climate risk weight policies in response to unaddressed systemic climate risk to the banking and financial sectors, reveals the latest issue of the central bank’s Macroprudential Bulletin. “Quantitative and qualitative restrictions on banks’ portfolios could also contribute to limiting the build-up of climate risks,” the authors find.

The ECB’s Macroprudential Bulletin is a monthly publication offering insights into the ECB’s work on macroprudential policy. The October issue focuses on the tools and policy reforms needed to manage climate risks and finance the transition towards a greener economy, and consists of five detailed articles by ECB researchers and analysts.

“The unique and complex features of climate risks, with their potential tipping points and non-linearities, represent a major challenge in terms of accurately capturing the impact of climate risks on the financial system,” the ECB believes. “To ensure financial stability, the unique features and the systemic dimensions of climate-related risks may require the application of macroprudential policies complementary to banks’ own risk management and direct supervision”

Capital-based macroprudential policies feature prominently among the recommendations for these complementary measures.

The bulletin includes an examination of climate risks in the banking regulatory framework and a theoretical model for explicitly incorporating climate risks into the capital framework for banks. Application of the model shows that climate transition risk generates excessive risk-taking without policy intervention.

Policies are examined in the context of the Basel Accords global banking regulations. Pillar 2 supervisory requirements are essential for addressing the climate risk exposure of individual banks, the ECB finds, but there are important gaps in Pillar 1 capital requirements. “Some parts of the Basel framework are backward-looking,” the authors say, and so do not adequately incorporate the forward-looking aspects of climate risks and uncertainty about how these risks will manifest over different time horizons and business cycles.

Earlier this year eight leading civil society organisations jointly called for Basel Pillar 1 capital requirements to be adapted to take into account the financial risks caused by fossil fuel exposures. They also called for climate risk buffers and for Basel Pillar 2 regulatory expectations to be expanded to include Paris-aligned climate targets, five-year transition plans and a mechanism to integrate climate criteria into financing decisions.

Research has found that climate systemic risks fall within the scope of the EU’s existing macroprudential framework and the Basel 3 international regulatory framework that it is based on. A variety of policy tools using capital requirements to mitigate this risk are recommended, including systemic risk buffers.

Industry analysts are also expecting capital-based climate-related policies from regulators. Earlier this week credit rating agency Fitch said the financial industry should prepare for the likelihood that there will be additional capital requirements tied to climate risk. “We may see things start with some kind of add-on or buffer or just more of a nominal charge to capital,” spokesperson Jo Lock said.

Other topics covered in this month’s bulletin include stress testing climate-related risk, an assessment of the EU green taxonomy, and movement towards a green capital markets union.

The publication is part of ECB efforts towards openness and discussion, and readers are invited to share views and feedback. “We aren’t trying to be transparent about our work just for the sake of it,” the bulletin’s website makes clear.