What are climate-adjusted capital requirements?

Climate-adjusted capital requirements (CACRs) are frequently discussed as an element in the bank regulator’s toolkit to address climate-related risks to the financial system. Although none  have yet been imposed, climate advocates are pushing for their implementation, legislators are introducing bills to require their use, and regulators are examining how to implement them.

What are climate-adjusted capital requirements?

CACRs would require banks to fund their loans that are made risky by climate change with increasing amounts of shareholder capital. This would make climate-affected loans more expensive, thereby incentivising banks to reduce their exposure to those assets.

Existing capital requirements require banks to fund a certain percentage of their investments with shareholder equity, and the rest is funded with deposits. This ensures that shareholders will take the first losses a bank faces, encouraging banks to make less risky loans than they would otherwise.

Capital requirements come in two forms – risk weights and leverage ratios. With risk weights, banks fund each asset with a percentage of shareholder equity and retained earnings equal to its risk weight multiplied by 8%, with each asset being given a risk weight from 0% (the safest possible) to 1250% (the riskiest).

As a result, banks can fund the safest possible assets entirely with deposits, and the riskiest must be funded entirely by shareholders. With leverage ratios, banks must fund their entire portfolios with a set percentage of capital, even if individual risk weights would require a lower amount.

In line with the two types of risk weights, there are two ways that CACRs could be implemented. First, regulators could impose a supplemental risk weight on, or otherwise replace the risk weight of, assets that are subject to climate-related physical or transition risks. For example, Finance Watch has proposed that new fossil fuel projects be given a 1,250% risk weight, otherwise known as the one-for-one rule, requiring these projects to be entirely funded by shareholder equity.

Second, regulators could enact a supplemental leverage ratio on institutions which are particularly at risk of failure as a result of climate change, something for which the Center for American Progress has advocated.

Challenges to implementing climate-adjusted capital requirements

There are both legal and practical challenges to implementing CACRs, and both relate to the lack of data about how climate change affects financial institutions. On the legal side, regulators in many jurisdictions may implement capital requirements only to ensure the safety and soundness of financial institutions or implement CACRs when there is evidence that assets subject to climate-related financial risks may cause losses to banks.

In other words, they cannot implement capital requirements for the purpose of allocating capital to particular types of investments. Without concrete evidence that climate risks cause banks significant losses, regulators may be prevented from enacting CACRs and that evidence may be difficult to come by.

Similarly, the lack of data necessary to identify the climate-related risks banks face with each asset poses practical challenges to implementing CACRs. In order to make adequate determinations as to appropriate adjustments, banks need to not only know how borrowers intend to use their loans (such as where will a building be constructed) and the climate-related risks that affect those activities, but also information about borrowers’ other activities and any associated climate-related risks.

Advocates of CACRs criticise this reliance on data. In a 2021 report , Finance Watch explains that “assets associated with exploration, expansion and exploitation of new fossil fuel reserves … will, with near certainty, become stranded and lose 100% of their value” under plans to achieve net-zero greenhouse gas emissions by 2050. Accordingly, even without data, a precautionary approach would dictate higher capital requirements than those currently required.

In addition, the Basel Committee on Banking Supervision (BCBS) has argued for banks to take “a more conservative approach” to assigning risk weights when they lack sufficient information to fully know borrowers’ climate risks.

Other challenges exist beyond the lack of data. Even where data may be available, for example, it is backward-looking whereas climate risks are uncertain and nonlinear. As a result, approaches taken by financial institutions towards CACRs are heterogeneous, and without regulators providing guidance as to a standardised approach, banks will assign different risk weights to similar assets and will not implement climate-adjusted leverage ratios.

Additional challenges include designing and calibrating CACRs so that risk weights are not reduced as a consequence of climate adjustments and regulatory arbitrage if jurisdictions do not adopt substantially similar CACRs.

What are the prospects for climate-adjusted capital requirements?

Multilateral standard setters, government regulators, and legislators all have a say in whether CACRs are implemented. The following provides an overview of the current state of play.

Multilateral standard setters

The BCBS, the main coordinating body for national banking supervisors, has not recommended that regulators impose specific risk weights to particular assets.

However, clarifications on climate-related financial risks released by the BCBS in December 2022 broadly requires banks to assess the risks posed to each asset, determine whether this analysis reflects higher risks than its official risk weight would suggest, and if so, assign that asset a higher risk weight. The clarifications also imply that supervisors may take climate risks into consideration when evaluating banks’ risk-weighting decisions.

Similarly, a report by the Financial Stability Board recommended that bank regulators enact a “system-wide approach to climate-related risks”, which would include “deployment of potential supervisory capital add-ons to address deficiencies in the risk management of climate-related risks”.

European Union

The European Central Bank (ECB) is perhaps the regulator that is furthest along in enacting CACRs. In November 2022, the ECB announced that it expects banks to meet all supervisory expectations on climate and environmental risks by the end of 2024, including the inclusion of such risks in its internal capital adequacy assessment process. This governs the processes by which banks manage their risks and may require banks to assign higher risk weights to assets vulnerable to climate risks.

ECB board members including François Villeroy de Galhau and Frank Elderson have similarly indicated that banks could face increased capital requirements as a result of greater information regarding climate risks. Members of the European Parliament’s economic affairs committee, however, have considered and rejected implementing CACRs by statute, although similar measures for crypto-assets have been adopted.

United Kingdom

The Bank of England (BoE) has indicated that it will not implement CACRs within the near future. In a 2021 report, the BoE dismissed the idea of using CACRs to encourage banks to increase green lending. Instead, the UK central bank merely opened the door to using them in addressing banks’ climate-related financial risks.

But in May 2022, deputy governor Sam Woods said that “it is not yet clear that the magnitude of transition costs require a fundamental recalibration of capital requirements for the system”. And in January 2023, a BoE spokesperson told Green Central Banking that any climate-related changes to its regulatory capital framework are on hold.

United States

The three US bank regulators – Federal Reserve, Comptroller of the Currency, and Federal Deposit Insurance Corporation (FDIC) – have all indicated that they will not be introducing CACRs soon. The chairs of the Fed and FDIC have both stated that regulators cannot and will not enact CACRs for the purpose of allocating capital to green projects.

In addition, acting comptroller Michael Hsu has previously stated that climate change risks will “eventually” be factored into capital rules, although there is no indication that the regulators intend to do so soon. National legislators have held hearings and introduced legislation to require CACRs, but that legislation has not been passed into law.

China

In 2021, Yi Gang, governor of the People’s Bank of China (PBoC), indicated that it may consider implementing CACRs to create “a positive regulatory incentive for financial institutions to have more green assets”. Since then, Chinese regulators have moved away from regulatory levers like CACRs, instead using mandates to encourage green lending.

In June 2022, the China Banking and Insurance Regulatory Commission issued guidance requiring banks and insurance companies to, among other things, “reduce the carbon intensity of their asset portfolios in a gradual and orderly manner, and eventually achieve carbon neutrality of asset portfolios” and “support key industries and fields in energy conservation, pollution reduction, carbon reduction, and greening.” However, it is unclear whether CACRs will be necessary following this advice.