Despite reforms enacted after the 2008 crisis, the global financial system remains fragile. The financial turmoil of 2023, which saw the collapse of institutions like Silicon Valley Bank and Credit Suisse, was not an anomaly but a symptom of a system ill-equipped for the profound shocks that may lie ahead.
The core of the problem is that we are now navigating an era of deep uncertainty, fundamentally different from a period of stability and quantifiable risks, in part due to a growing, formidable threat: environmental degradation.
Geopolitics aside, much uncertainty stems from the escalating and unpredictable nature of environmental change, characterised by non-linear feedback loops, variable time lags and the potential for irreversible tipping points. These dynamics render traditional financial models and regulatory frameworks obsolete.
Addressing environment-related financial hazards (EFHs) necessitates a fundamental shift in approach; moving away from the pretense of knowledge and the quest for false precision, towards building genuine and durable resilience.
Traditional climate models are inadequate
The models currently used to assess financial stability are deficient for the age of environmental change. Complicated tools like the integrated assessment models, which are often used by bodies such as the Network for Greening the Financial System, simply cannot grasp the sheer scale of the physical, transition and liability risks we face.
These models are unable to properly account for catastrophic tipping points, path-dependent structural changes and the complex interplay between the financial sector and the real economy, especially under stress. This analytical failure leads to a systematic underestimation of risk and a false sense of security.
Given the potential for severe and irreversible harm from environmental change, a shift to a pre-damage control approach based on the precautionary principle is essential. This principle dictates that if a policy or activity has the possibility of causing sufficiently serious or morally unacceptable harm, it should not be permitted without near-certain scientific evidence of its safety.
The burden of proof falls on those proposing the activity and traditional cost-benefit analyses cannot be applied because they rely on assigning probabilities to outcomes that, in a world of deep uncertainty, may be unknowable.
The prevailing regulatory architecture for banking – the Basel framework – is also increasingly untenable as it rests on the availability of large spans of data and slowly evolving economic relationships. Widespread digitalisation of economies and the expansion of non-bank finance, along with its interconnections with banks and capital markets, has led to a proliferation of links that are not yet fully understood or tracked.
Such linkages create complementarities but also produce conflicts of interest; they offer risk reduction but also the potential for risk amplification, and may generate a higher likelihood of unintended consequences in the tangle of interactions.
Five pillars for a resilient financial system
To confront these challenges, I propose a new framework, prioritising simplicity, robustness and structural integrity over flawed complexity. It rests on five central pillars:
1. Simplicity in rules
The first pillar calls for abandoning the arcane intricacies of the Basel risk-weights framework. In its place, a simple, transparent leverage ratio (defined as equity divided by total assets) should be adopted as the primary measure of solvency. This ratio is easier to calculate and understand, less susceptible to manipulation and has been shown to be a more reliable predictor of an intermediary’s true strength.
2. Higher buffers
The second pillar advocates for substantially increasing equity levels to buffer institutions against unpredictable shocks. It is crucial to understand that equity is a source of funding; it is not idle capital. Higher equity makes for greater safety, thereby lowering the cost of funding, curtailing the moral hazard that encourages excessive risk-taking, and protecting taxpayers from providing bailouts.
3. Greater modularity
As in complex adaptive systems, the third pillar builds resilience by modularising the financial system. There are two key proposals.
First is a modern Glass-Steagall Act to structurally separate speculative investment activities from core commercial banking, which benefits from public safety nets like deposit insurance. Institutions like universal banks that combine these functions are inherently dangerous, fostering conflicts of interest and unsustainable credit booms that have historically ended in systemic crises.
Second is using central bank digital currencies to separate money creation and the payment system from private credit intermediation. By replacing runnable demand deposits with a digital currency that is the direct liability of the central bank, credit disruptions would not compromise the payment system and impede the functioning of the real economy. The possibility of bank runs would be substantially reduced, thereby containing financial crises before they metastasize. Also, regulatory arbitrage would decrease as private credit-extending institutions are put on an equal footing.
4. Effective market and public discipline
Simpler rules and the greater transparency that comes from a more modular system are prerequisites for the fourth pillar: empowering markets and the public to hold financial institutions accountable. When a bank’s health can be assessed via a simple leverage ratio rather than a black box of risk-weights, market discipline becomes far more effective.
5. Credible and effective supervision
A simplified framework is also the foundation for the fifth pillar. It would free supervisors from the role of compliance checkers, allowing them to focus their resources on identifying and mitigating genuine systemic threats.
The evolving mandate of central banks and financial regulators
The role of central banks and financial regulators in shepherding the green transition needs to be rethought. The long-held notion that central banks can remain neutral is a fallacy; their every action, from setting interest rates to quantitative easing, has distributional and allocative consequences.
Countries realise that the core objectives of price and financial stability are unachievable without paying attention to environmental sustainability. The critical debate is no longer whether central banks and regulators should act on environmental threats, but how.
This has created a palpable tension between the need for effectiveness (output legitimacy) and the constraints of unelected power (input legitimacy). This friction is visible in the diverging paths of major central banks.
For example, the European Central Bank appears more proactive, embedding climate considerations into its supervisory reviews and pushing for double materiality – assessing both the risk of the environment to a firm and the risk of the firm to the environment. In contrast, the US Federal Reserve remains far more cautious, constrained by polarised domestic politics that questions its mandate to act on environmental issues.
We are at a watershed moment as the world, already saddled with fiscal and financial dominance, enters a period of climate dominance. Incremental adjustments are dangerously insufficient for the scale of the challenge.
In an era of deep uncertainty, simple and robust rules are our most effective first line of defence. Achieving durable economic and financial stability demands bold structural reforms and a courageous rethinking of the mandates and responsibilities of the institutions at the heart of our economies. These changes are required to proactively build a system that can shape the transition and withstand the shocks from environmental change.
The path forward requires political courage to confront powerful interests that benefit from the current fragile, debt-fuelled system. The cost of inaction is not merely financial; it threatens the stability of our societies and the prospect of a livable future on a changing planet.
This page was last updated December 9, 2025
Written by
Sunil Sharma is a distinguished visiting scholar at the Institute for International Economic Policy and the Elliott School of International Affairs, George Washington University. He is a senior associate at the Council on Economic Policies and an advisory council member at North Star Transition.
