Climate risk and the EU's macroprudential response Photo by Aditya Chinchure via Unsplash

Climate risk and the EU's macroprudential response

The impact of climate risk on human life is rising, also in the financial field. Can the current macroprudential regulatory measures in the European banking sector meet the challenges of climate risk?

Banks play a vital role in the efficient allocation of capital in the economy, providing services such as deposits, loans, investments and insurance. Banking stability is the foundation of financial stability. The insolvency of banks could harm the real economy: lending operations could come to a halt, deposits might not be able to be withdrawn, and the capital chain of projects in which the bank has invested could break down. The consequences of such disruption could be unemployment and social unrest.

Therefore, the safety and soundness of banks is a key legal and policy concern. Banking supervisory authorities in Europe act as ‘parents’, maintaining prudential attitudes towards banking risk assessment and risk prevention. They hope to limit the risk of bank failures and the economic panic they might cause. This is what is called the EU macroprudential framework for the Banking Sector. Both the ECB and national competent authorities are actively monitoring changes in risks and optimising the macroprudential framework in due time so that it can respond to current and future systemic risks. Among these macroprudential measures, the pillar one, pillar two, and pillar three of the Basel Accords are central. The Basel Accords emphasise the risk model design and risk prediction, which play an important role in maintaining financial stability in the banking sector, limiting excessive lending and providing a complete framework for risk management. The Basel Accords and other existing EU banking macroprudential regulatory tools can provide a degree of defence against climate risk. The question is whether this defence is sufficient.

The threat to the banking sector from climate risk can be divided into physical risks and transition risks. Transition risks are more likely to be anticipated than physical risks. A warming planet will result in an increase in the frequency and intensity of natural catastrophes (i.e. physical risks), which could lead to more direct and indirect losses for financial institutions, including banks. At the same time, transition risks may arise from the transition to ‘greener’ activities, the process driven by regulatory changes. This transition from carbon-intensive activities can slow economic growth in the short term and will indirectly affect the profitability of banks. In addition, transition risks can affect financial stability, for example the sudden repricing of carbon-intensive products. Overall, climate risk can affect the sustainability of the banking sector by increasing its volatility and raising insolvency risk. It is therefore necessary to effectively address climate risk. Current research suggests that climate risk can, to some extent, be incorporated into existing risk prediction models. In other words, existing risk prediction models and risk calculation methods are able to cope with a portion of climate risk. This is what some academics and financial institutions are working on right now.

However, due to the specific nature of climate risk, it is difficult to capture or predict. It is neither sufficient nor wise to only rely on traditional risk prediction methods to deal with climate risk. It is recommended that an internal categorisation approach be used. First, for physical risks, financial regulators could work with climate experts to categorise physical risks in observable and unobservable risks. The observable portion could be incorporated into Basel risk prediction models, while the unobservable portion would require additional attention. In addition to the Basel Accords, there are other existing macroprudential tools whose applicability to climate risk is also a concern. For example, the systemic risk buffer (SyRB) aims to address systemic risks that are not covered by the Capital Requirements Regulation or by the CCyB or the G-SII/O- SII buffers. Also, the capital conservation buffer is a capital buffer amounting to 2.5% of a bank's total exposures. These traditional capital buffers are not well-designed to cope with the systemic risks posed by climate change. They focus on traditional systemic risks based on predictable economic cycles, but lack consideration of climate risk.

Climate risk will be long-lasting and unpredictable, and the task of addressing it is urgent for European banks. There should be new macroprudential tools, such as particular climate risk buffers. In addition, non-capital instruments could also be considered, such as an increase in interest rates by banks for specific industries with larger climate risk exposures and the requirement of adequate collateralisation by borrowers. The EU should try different green credit policies and monetary policies, etc.

When it comes to the traditional macroprudential regulatory framework, climate risk is not only a challenge, but also an opportunity for change.

1 Comment

Bart Joosen

Indeed, currently the European institutions are exploring the application of macroprudential tools to address climate change risks for the banking industry. This particular development may also be framed into the need to find a temporary solution for the pricing in of climate change risk, awaiting the further development of the microprudential toolkit as currently been developed in Europe, based on the work of the European Banking Authority in the summer of 2021 (Report on management and supervision of ESG risks for credit institutions and investment firms).

It is the expectation, however, that once the microprudential framework is being completed, the need for the application of macroprudential measures in this area will likely to be less important in the future. I am one of the academics researching this particlar development focussing on the changes to the microprudential framework, and the preliminary hypothesis is that the existing risk measurement rules are likely to be inadequate, rather an 'out-of-the-box' solution shall be necessary to properly address climate change risks.

Prof Bart Joosen, Institute for Private Law, Hazelhoff Centre for Financial Law

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