Preventing a ‘Climate Minsky Moment’: Environmental Financial Risks and Prudential Exposure Limits

A sudden collapse in carbon-intensive asset values is increasingly likely, warns this groundbreaking report from the London School of Economics’ Grantham Research Institute.

The scale of the policy response required to avoid runaway global heating and stay within the Paris Agreement targets is not being matched by the mitigation actions of transition-sensitive industries, the study shows. This suggests that increased regulation of large exposures can help central banks and financial regulators avoid the growing possibility of a ‘climate Minsky moment’.

Popularised following the 2008 financial collapse and named after the theories of economist Herman Minsky, a Minsky moment refers to a market tipping point and collapse as a result of regulatory blind spots in which risks are not recognised or mitigated.

The concept of a climate Minsky moment was first identified by former Bank of England (BoE) governor Mark Carney in his pivotal Tragedy of the Horizon speech, and would involve a sudden adjustment of investor expectations about future climate policies and the resulting fire sale of affected assets as the risk is repriced.

A sectoral analysis of companies within transition-sensitive industries suggests misalignment with climate policy targets and delays in mitigation action, the report finds. This misalignment increases the likelihood that the global economy is heading for a disorderly transition to net zero with an associated asset collapse and resulting defaults.

The study first examines the financial risks and challenges of the societal and policy movement to net zero, before assessing and identifying transition risks of particular relevance. Turning to prudential management, authors Hugh Miller and Simon Dikau make a series of proposals for mitigating these growing risks to financial stability. While focusing on the BoE and the UK’s Prudential Regulation Authority, they make clear these recommendations are also highly relevant for other central banks and financial supervisors.

They suggest that the BoE could adjust its large exposures regulation to account for the relevant climate transition risks, introducing a ‘soft limit’ of 25% of eligible capital for aggregate large exposures to exposed economic sectors by commercial banks. Banks exceeding this limit would be required to make additional climate-related disclosures relating to the mitigation strategies of companies in banks’ portfolios.

The report concludes with a series of next steps and recommendations, including that the BoE assess banks’ large exposures to transition-sensitive sectors and the climate policy impacts on underlying companies within these exposures. It also recommends several calibration adjustments of the current large exposures regime, including increased granularity in current sectoral reporting within the framework and development of sector-specific expertise to understand climate-related risks to the real economy.