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The tremendous macro-economic consequences of the looming climate crisis are forcing financial supervisors to acknowledge that regulatory action on climate risks is necessary in order to fulfil their financial stability mandate. Indeed, by financing the fossil fuel industry, financial institutions contribute to accelerating climate change and themselves incur both micro and macroprudential risks. These climate-related financial risks are not yet taken into account in prudential rules to make sure that financial institutions will be able to withstand inevitable losses. But how to proceed exactly? This executive summary reviews the existing policy options under the current prudential rules (Basel III pillars) and pleads for the mobilisation of the “Pillar I” capital buffers against this new systemic risk.
The world’s leading regulators, supervisors and researchers have long recognised the link between climate change and financial stability. Financial institutions contribute to accelerating climate change by financing greenhouse gas emitting activities. In turn, they themselves are impacted by the devastating consequences of climate-related events, as well as transition measures towards a more sustainable economy. Analyses by the Intergovernmental Panel on Climate Change (IPCC) and the International Energy Agency (IEA) confirm the urgent need to reduce greenhouse gas emissions and warn of the devastating consequences of delaying action. This means that, in order to avoid a climate-related financial crisis, actions to address the risks that climate change poses to the financial system need to be taken without undue delays.
Much policy debate swirls around possible prudential policy measures to effectively address climate-related financial risks and ensure the financial sector’s resilience. Tackling the risk of “green swans” represents a particular challenge. “Green swans” are defined as disruptive climate-related events, which pose an existential threat the economy and humanity, with the dual characteristic of being certain to occur and of commanding highly unpredictable consequences. As prudential regulation for banks and insurance companies is based on three sets – or “pillars” – of rules, each holds potential to address the problem. Given the current circumstances, capital measures applied under Pillar I provide the most coherent, impactful and feasible solution – “a silver bullet” against “green swans”.