Climate-related prudential measures must be carefully calibrated in order to avoid migrating risks to smaller lenders and undermining financial inclusion, economists at the World Bank have warned.
Their caution follows a study which evaluated the effects of a 2017 policy introduced in Brazil requiring systemically important banks to incorporate environmental risks in their capital adequacy assessments. According to the study, the policy led to sharp contraction of credit to polluting sectors by large banks. But at the same time smaller banks also experienced a noticeable increase in exposure to the same sectors.
“The shift in exposure of environmental risks from large to small banks in our setting highlights the importance of safeguarding the entire financial system when implementing climate-related prudential measures,” the authors argued.
Whereas the Brazilian policy was tailored to individual institutions depending on their size, central banks are increasingly being urged to integrate climate considerations into the minimum capital requirements applied to all banks.
Pierre Monnin, a senior fellow at the Council for Economic Policies, wrote in a recent article for Green Central Banking that climate risks share several features with other systemic risks, meaning that the existing macroprudential framework provides a good basis to address them. He said systemic risk buffers and concentration limits should be used as part of a holistic approach towards addressing climate risk using all elements of central banks’ prudential toolkits.
The World Bank study also found that while many firms were insulated from the effects of the measure as they could substitute credit across lenders, climate-related capital requirements may disproportionately affect borrowers who are less able to shop around.
“An unintended consequence of prudential measures that should be closely monitored is the negative impact on financial inclusion,” said the researchers.
The paper also found that where banks continued to lend to high-carbon borrowers, there was a shift towards shorter loan maturities.
This page was last updated February 1, 2023
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