The banking sector cannot escape climate risk. If countries honour their Paris Agreement commitments and governments implement policies to decarbonise energy systems, a significant percentage of existing fossil fuel assets will lose their value and become stranded.
This poses substantial risks for banks financing fossil industries, most notably credit risk. Meanwhile, a delayed and disorderly transition would only worsen the situation as a sudden shift in climate policy could cause large swings in asset prices, leading to financial instability.
This “too late, too sudden” transition is acknowledged as a costly scenario for financial institutions which would face enormous losses. But failing to transition at all would be worse, resulting in catastrophic physical impacts including extreme weather, supply chain disruptions and societal upheaval, with systemic financial risks growing exponentially.
Despite this, climate-related risk is still largely seen as an “externality” in the financial system, meaning it is not reflected in banks’ capital requirements. The Basel Committee on Banking Supervision (BCBS) has so far refrained from incorporating climate risk into the Pillar 1 capital requirements, instead concentrating on qualitative principle-based requirements and leaving national regulators to take action as they see fit.
Predictably, major jurisdictions have been reluctant to make the first move, fearing that stricter requirements would put their banks at a competitive disadvantage. As a result, the global banking sector remains significantly exposed to climate-related financial risks.
Meanwhile, banks continue to fund activities that are universally recognised as contributing to climate change. In 2023 alone, 60 of the world’s largest banks provided US$706bn in funding to the fossil fuel sector, including $347bn for exploration and expansion projects.
According to the International Panel on Climate Change and the Carbon Tracker Initiative, the global carbon emissions budget could be exhausted in as little as two-and-a-half years if emissions continue at current levels. In fact, with the existing decarbonisation policies in place the world is currently on track to reach a global temperatures rise of 3ºC and above, which suggests the risk of major climate disruptions.
Limitations of the current risk approach
Among supervisors, there is broad recognition of the growing financial stability risks tied to climate change. At the international level, the Financial Stability Board has a coordinating role, with different initiatives outlined in the board’s Roadmap for Addressing Climate-Related Financial Risks endorsed by the G20. The roadmap outlined the need for a holistic review of the Basel framework to assess materiality gaps and consider new regulatory measures to address climate risks.
Despite the availability of simple, technically sound proposals, the BCBS has yet to adopt Pillar 1 capital measures that reflect climate risk. While progress has been made on Pillar 2 (risk management) and Pillar 3 (market transparency), the core capital requirements under Pillar 1 remain unchanged.
The European Banking Authority (EBA) is among a few regulators that are beginning to acknowledge the scale and the challenge of climate-related financial risks. In 2023, the EBA released a report that examined whether capital requirements should be adjusted to account for the environmental and social risks faced by banks.
The report highlighted the conceptual difficulties of applying the current Basel framework to climate-related risks, citing the reliance on short-term historical data which is poorly suited to capture the future impact of climate change. Traditional risk models focus on parameters estimated over short horizons, often just one year, whereas climate-related risks play out over decades.
The EBA’s findings are a stark reminder that climate-related financial risks do not fit neatly within the traditional Basel framework. The radical uncertainty of climate change, including the possibility of tipping points and abrupt shifts in asset values, challenges the risk assessments that underpin the current prudential system. The inability to reflect future risks accurately results in the continued under-pricing of climate-related financial exposures.
What’s clear is that, as it stands, the Basel framework is ill-equipped to address the unique and systemic risks posed by climate change. Moving forward, the framework must evolve towards a forward-looking precautionary approach, expanding Pillar 1 to incorporate climate-related risks into core capital requirements. This would ensure that banks have adequate loss-absorption capacity and are not overly reliant on short-term data to make long-term risk assessments.
Evolving the Basel framework
The future development of physical- and transition-related climate risks is dependent on when and how steps towards a net-zero economy are taken: the longer the transition is delayed, the less transition-related risk financial institutions face in the short term, yet the larger the physical impacts of climate change grow at the systemic level.
Banks are not mere risk-takers as assumed in the microprudential approach: they influence the transition path of the economy and the possible routes to decarbonisation by allocating capital to certain sectors and companies. Taking into account the interaction between the financial institutions and their environment, these risks can be addressed by deploying macroprudential tools. These instruments are conceived to be forward-looking, preventing the build-up of risks in the financial system. This makes their use in the short-term feasible and pragmatic.
Finance Watch has proposed the introduction of a new macroprudential tool, such as a loan-to-value (LTV) threshold for fossil fuel exposures. Under this approach, banks would face a capital surcharge once their exposure to fossil fuel-related risks exceeded a specified threshold, which would be calibrated based on the remaining carbon budget of the planet. This would directly address the systemic risks tied to fossil fuel financing, shifting the risk-return considerations of banks.
It is clear that capital requirements must evolve to address the financial risks posed by climate change. As the systemic risks associated with climate change grow, so too does the urgency for regulatory reform.
A new report from Finance Watch lays out how the Basel 3 framework can be improved to guard against the risk posed by climate change to financial stability. The Basel Committee should expand Pillar 1 of the risk-based prudential framework to account for financial risk related to climate change. To capture systemic risk arising from banks’ continued exposure to fossil fuel assets and activities, the committee should also consider adapting existing macroprudential tools, such as the systemic risk buffer, which could be supplemented with the introduction of an LTV threshold on banks’ fossil fuel exposures.
Without comprehensive adjustments to the capital framework, the global banking sector will remain vulnerable to climate-related shocks with potentially devastating consequences for both the financial system and society at large.
This page was last updated November 5, 2024
Written by
Julia Symon is head of research and advocacy at Brussels-based Finance Watch, with a focus on banking and insurance prudential regulation and climate risk. Prior to joining Finance Watch, she worked as an audit manager for large international banks in Frankfurt and Munich.
