Macroprudential Policies for Addressing Climate-related Financial Risks

In light of the material and increasing risks posed by climate change, there is a “strong case” for financial authorities to adjust their prudential frameworks, according to this research by the Financial Stability Institute.

Given the potential system-wide risks to financial stability, the authors say that authorities should develop climate-related macroprudential policies alongside climate-specific adjustments to all three pillars of the Basel framework’s microprudential standards. However, they add that macroprudential measures must be “carefully designed” to avoid counterproductive consequences for financial stability. This paper considers the specific challenges and trade-offs this entails.

According to the paper, climate-related risks may materialise as system-wide shocks that distress financial markets and trigger sharp asset price corrections which simultaneously affect multiple financial institutions. While banks are increasingly managing these risks individually, the systemic dimensions are unlikely to be accounted for by individual banks’ risk assessments.

Macroprudential toolkits were instituted following the global financial crisis in 2008 to build resilience and safeguard economic stability. They complement the microprudential framework and address structural vulnerabilities and risk accumulation by targeting common exposures, loss absorption and systematically damaging risk incentives through policies such as capital add-ons on specific exposures, risk buffers and exposure limits.

Adapting this toolkit for climate related risks brings forward unique challenges. For instance, measures may increase physical and transition risks if they reduce resources available for transition in climate-vulnerable areas and hard-to-abate sectors. Additionally, they may create financial shocks if banks rush to reduce their exposures. To address this, the authors say regulators should tackle two key trade-offs.

First, authorities must assess whether measures should target the carbon exposure of existing stock in addition to new loans. Targeting existing stocks accelerates the unwinding of exposures, but may instigate an abrupt transition. While targeting only new loans allows for greater flexibility, it may be too slow to have significant effect, especially if it does not include renegotiation and renewals. To address this, the authors recommend applying stricter measures only to new loans initially, including renewals, and phasing them in for existing stock.

Second, as a way to mitigate the risk that measures could hinder the provision of transition finance, authorities should consider whether to apply policies at the firm or project level. For macroprudential purposes, the authors recommend targeting project level, stating that this would contribute to mitigating transition risks rather than amplifying them.

These policies should complement microprudential regulations that cover “all their existing exposures” to high-emitting counterparties and take a firm-based approach.