Designing a Macroprudential Capital Buffer for Climate-related Risks

July 3, 2024Published by European Central Bank

Regulators are increasingly recognising that capital risk buffers can help build resilience against systemic climate risks, but there is a critical gap in research on practical implementation. A study by European Central Bank (ECB) researchers aims to address this by providing a detailed methodology for calibrating systemic risk buffers to address short-term transition-related climate risks in Europe.

They propose buffer requirements are tailored to the specific risk profiles and expected transition-related losses of financial institutions, due in part to wide variation in bank exposures. This precautionary and targeted measure also provides dynamic incentives for institutions to address transition risks, say authors Florian Bartsch, Iulia Busies, Tina Emambakhsh, Michael Grill, Mathieu Simoens, Martina Spaggiari and Fabio Tamburrini.

Systemic risk buffers (SyRB) are additional capital requirements imposed on financial institutions to mitigate against risks to the stability of the entire financial system. Climate-related risks are suitable for SyRBs as such risks “introduce significant systemic vulnerabilities within the banking sector”, state the ECB researchers.

The authors employ scenario analysis, which builds on the ECB’s second economy-wide climate stress test, to estimate the impact of transition risk on probabilities of default and expected bank losses under different transition trajectories. The study uses granular loan-level data to assess the exposure of 104 significant institutions across 19 euro area countries between 2023 and 2025. They consider both baseline and adverse macroeconomic scenarios.

To avoid double counting and isolate transition-related effects, they compare results from current policy and accelerated transition scenarios.

The results show that aggregate losses from an abrupt transition can be substantial, particularly for financial institutions heavily exposed to carbon-intensive sectors. Transition losses under an unanticipated accelerated transition scenario are estimated at around €52bn; reaching €72bn under adverse macroeconomic conditions.

These findings highlight the need for alternative calibration options to account for potential policy trade-offs under varying macroeconomic conditions.

The authors’ calibration methodology is built on a multi-rate bucket approach that groups institutions based on their risk exposure and applies different buffer rates to each bucket. Thresholds for each band are based on the distribution of expected losses and rates are calculated to cover the expected losses in that group.

The size of the buffer varies depending on the calibration factor, namely whether authorities aim to absorb all or a fraction of projected losses. To absorb all losses, a SyRB of €51bn is required in the baseline macroeconomic scenario, reaching €69bn under a scenario of substantial macroeconomic stress.

The results also show that introducing buffers during economic stress can significantly impact credit supply and growth, meaning policymakers should adopt a gradual approach and consider possible trade-offs.

Finally, the authors recognise the study’s limitations, such as excluding physical risks and systemic risk channels like fire sale dynamics and second round effects. They stress the results should be taken as a lower bound estimate. They emphasise that the calibration process is iterative and, as climate risk modelling improves, the methodology can be refined and buffer rates recalibrated using more comprehensive risk assessments.

This page was last updated July 4, 2024

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