Macroprudential Policies and Climate Risks

According to this working paper published by the European Banking Institute, it is “widely acknowledged” that climate shocks pose systemic risks, yet ”little has happened” to reduce the financial system’s vulnerabilities. The paper emphasises the need for macroprudential policy responses to prevent the accumulation of systemic climate-related financial risks (CRFR) on a “potentially catastrophic” scale. Systemic risk buffers and adapted leverage ratios are presented as the most viable macroprudential options for increasing the Eurosystem’s climate resilience.

Author Seraina Grunewald of Radboud University in the Netherlands explains that financial supervisors frequently underprice CRFRs and continue to provide excessive credit to carbon assets. This exacerbates the financial system’s exposure to systemic risk and necessitates macroprudential intervention. The paper states that while microprudential supervisors are increasingly incorporating CRFRs into risk management practices, the systemic aspects are rarely captured.

Yet as Grunewald highlights, the twin drivers of physical and transition risk threaten complex, non-linear and interconnected system-wide impacts, which means that macroprudential policy has a “natural role to play” to address the ongoing accumulation of risk.

In light of the EU Commission’s ongoing climate review of its macroprudential toolkit, this paper explores both “soft” macroprudential tools whichaddress CRFRs through analysis, as well as the “hard” tools currently available to financial supervisors under existing EU law. The paper explains how the tools, which were instituted in the wake of the financial crisis, could be adapted to promote financial stability alongside addressing climate change.

The paper begins by outlining the ongoing advances made by macroprudential authorities incapturing the specificity of CRFRs through exposure analysis, stress testing and risk modelling. Key findings from the economy-wide climate stress test conducted by the European Central Bank and European Systemic Risk Board show that: banks have maintained large exposures to climate-intensive sectors, particularly in mining, manufacturing and electricity, despite their substantial vulnerability to heat and water stress; there is a high concentration of risk in specific sectors, geographies and firms; and how severely climate-related risks materialise depends on the efficacy of transition pathways.

Informed by the findings of soft macroprudential approaches, the paper then reviews the hard tools available under the Eurozone’s existing legal framework, and in particular, presents the case for using systemic risk buffers (SyRB) to address climate-risk.

According to the paper, it is “legally feasible” under the existing framework to apply a sectoral SyRB to a subset of emission-intensive exposures. SyRBs impose targeted capital requirements to counteract long-term systemic risks to the real economy. Geographical SyRBs that apply to high emitters in areas of concentrated physical risks could also be used, although Grunewald notes that detailed criteria would be needed to clarify the parameters of both.

The paper also considers which macroprudential tools could be adapted to address CRFRs, concluding that sectoral leverage ratios and large exposure limits may be viable options. Due to the potentially costly nature of reporting required by large exposure limits, Grunewald proposes sectoral leverage ratios as a “simpler and equally effective alternative”. A sectoral leverage ratio applied to emission-intensive sectors would reduce the leverage a bank may use to finance activities in these sectors.

As the leverage ratio cannot be applied at a sectoral level under the current legal framework, legal amendments to capital requirements regulations would be required.