Systemic Risk Buffers – The Missing Piece in the Prudential Response to Climate Risks

Systemic risk buffers require financial institutions to hold adequate capital to mitigate specific systemic risks. In this groundbreaking policy brief from the Council on Economic Policies, Senior Fellow Pierre Monnin argues for their use in mitigating systemic climate risk, calibrated to reflect the exposure of individual institutions.

The brief begins by describing how climate risks are systemic risks to financial and economic stability and can trigger “sharp and hasty” falls in asset prices, amplified by financial markets. Focusing on Europe and using analysis from the European Central Bank, Monnin highlights that this risk is concentrated in certain economic sectors and geographical areas, and thus in specific financial institutions. More than 70% of the banking system’s credit exposure to fossil fuel and other high-risk firms are held by only 25 banks, he points out, with the total assets of those banks representing 64% of the entire banking system.

The policy brief then examines how existing systemic risk buffers are used in Europe. Based on the Basel III international regulatory framework, the EU macroprudential framework aims at mitigating several sources of systemic risk and offers several policy tools using capital requirements to ‘buffer’ and mitigate this risk. Climate systemic risks fall within the scope of these systemic risk buffers, Monnin shows, referring to the EU’s Capital Requirement Directive. EU supervisors already have strong expertise in using systemic risk buffers, he writes, and these tools can and also should be used to address climate systemic risks.

The paper then offers a series of policy recommendations for how European financial supervisors can use systemic risk buffers to mitigate climate-related risks to financial stability. Climate systemic risk buffers should be institution-specific, he proposes, requiring each financial institution to hold capital in proportion to their individual exposure to climate risks. Financial supervisors should target high exposures to climate risks, with empirical assessment based on transparent rules and metrics, he suggests. Climate systemic risk buffers should be implemented by national supervisors with common guidelines provided by the European Systemic Risk Board (ESRB).

Concentrated climate risks are a major systemic risk to the European financial system, Monnin concludes. “Systemic risk buffers have been used by EU financial supervisors for almost a decade to address systemic risks and exposure to specific shocks to the economy. They are thus particularly well suited to mitigate climate systemic risks.”

A recent major study found that the 11 largest Eurozone banks have accumulated €532 billion in fossil fuel assets, representing 95% of their total equity and exposing them to a collapse in fossil fuel asset values, with associated systemic disruption. Another recent study by the Danmarks Nationalbank found the Danish financial system exposed to flooding risk through the concentration of that risk in particular financial institutions.