07 December 2022

CEPR: Climate risks are real and need to become part of bank capital regulation

van Tilburg, Grünewald, Schoenmaker, Boot: Climate risks are building up on banks’ balance sheets. Supervisory reviews show that banks are not well prepared. Yet, supervisors have been slow to include climate risks in minimum capital requirements.

This column argues that doing so would speed up the transition to a low-carbon economy. Given the urgency of addressing the environmental risks that are now largely not accounted for, speed is of the essence.

In 2023 it will be decided if and how to integrate climate and environmental risks in the prudential rules for European banks. The update of the Capital Requirements Regulation and Directive (CRR/CRD) provides a rare opportunity to do so. These climate and environmental risks encompass ‘physical risks’ from, for example, a changing climate (such as wildfires, hurricanes and droughts that damage or destroy assets) and ‘transition risks’ triggered, for example, by new innovations and regulations that limit climate change and can turn existing assets into stranded assets. It has, by now, been well established that climate and environmental risks are material financial risks (NGFS 2019, ECB 2020, De Arriba-Sellier 2021). As an illustration, one only needs to look at the devastation of the wildfires and floodings that have hit Europe over the last few years.

Banks are not prepared

The 186 largest European banks are still far from meeting the ECB’s supervisory expectations relating to risk management (ECB 2022). In the words of the Vice-Chair of the Supervisory Board of the ECB, Frank Elderson (2022), “the glass is filling up slowly but it is not yet even half full”. The ECB found ‘blind spots’ in 96% of the banks, concluding that “almost all boards are still unaware of how these risks will develop over time, what precise risk level the bank can accept and what action it will take to rein in excessive risk”.

The ECB (2022) found that only a handful of frontrunners had voluntarily allocated economic capital for climate risks as part of their Internal Capital Adequacy Assessment Process (ICAAP). For a small number of banks, their lagging performance fed into their Supervisory Review and Evaluation Process (SREP)-scores, resulting in higher Pillar 2 capital requirements. Most importantly, the ECB set 2024 as the date for banks to comply with its supervisory expectations.

Minimum capital requirements are needed

Important as this development in the second pillar of the capital regulation is, more is needed. It is Pillar 1 on mandatory regulatory minimum capital requirements that drives credit decisions within banks on a permanent basis. It is for that reason indispensable that climate and environmental risks are also reflected there (Schoenmaker and Stegeman 2023).

This is by no means a new thought. It is more than ten years since the Carbon Bubble report put transition risk on the table (Carbon Tracker Initiative 2011). In 2015, Mark Carney warned of a “climate Minsky moment” (Carney 2015). Since then, climate and environmental risks have entered the mainstream amongst financial supervisors, resulting in a barrage of stress tests and scenario studies, but without leading to much substance in terms of real change in the capital requirements faced by banks (Schoenmaker and van Tilburg 2016, Campiglio et al. 2018, Smolenska and van ‘t Klooster 2022). As the ECB (2022) testifies, to date it has had little impact on the actual lending policies of European banks....

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