Greening Capital Requirements

This briefing from the Inspire research network makes the case for green differentiated capital requirements (GDCRs) as a tool to decarbonise the financial system and reduce the buildup of physical environmental risks.

The paper argues that GDCRs should be used as part of a strong macroprudential approach. This takes into account the presence of macrofinancial feedback loops, whereby the financial system can contribute to the proliferation of systemic environmental risks which it is then exposed to. The authors say that, as part of such an approach, tools including GDCRs can be used to help ensure the financial system has positive impacts on the environment, which in turn can promote the long-term stability of the financial system.

The briefing offers several insights regarding the implementation of GDCRs in practice. For example, it suggests financial regulators should identify the environmental footprint of bank assets using both borrower-level environmental metrics and information about the types of activities that borrowers engage in.

The paper also suggests that adjustments to capital requirements should be combined with other financial and monetary interventions, in order to avoid regulatory arbitrage where firms seek to circumnavigate unfavourable regulatory conditions. This could include greening central bank corporate bond purchases and collateral frameworks to avoid polluting firms using bond markets to finance their spending.

The authors argue that GDCRs can be more effective if they are combined with green fiscal policies. For example, if risk weights for green loans were reduced alongside higher green subsidies and carbon taxation, this may increase the scope of banks to lend towards greener activities.