Report: A ‘silver bullet’ against Green Swans – Incorporating climate risk into prudential rules

23 November 2021

Report

Simple measures taken now can sever climate change-financial instability link, says a new report “A silver bullet against green swans: Incorporating climate-related financial risk into bank and insurance prudential rules”.

The paper explores a wide array of prudential measures to tackle climate-related financial risk. It concludes that a climate-driven financial crisis can be thwarted if climate-related financial risks get inserted ‘without delay’ into EU bank and insurance prudential capital rules. As wider work on prudential measures continues, quick fixes to capital rules can address risks climate change poses on the financial system. In particular, the EU CRR/CRD and Solvency II review opens a window to act now.

  • The “silver bullet” lies in minimum capital requirements for financial firms who finance greenhouse gas-emitting fossil-fuel projects.

The change would force banks and insurance firms to seek out and address climate-related financial risk and build up more capital to absorb inevitable losses brought by events stemming from those risks.

  • Capital requirements matching climate risk profile: A precautionary approach 

Implementing one-for-one capital requirements for the financing of new fossil fuels means that for each euro that finances new fossil fuels projects, banks and insurers must have a euro of their own funds held liable for potential losses.

A precautionary approach, ‘one-for-one‘ is coherent with the risk-based nature of prudential regulation: It brings requirements for financing fossil fuel activities – the major contributors to climate change and financial instability induced by it in line with their climate risk profile. It also overcomes existing data and methodological challenges aimed at a precise, yet elusive measure of climate risks.

  • Pillar II and Pillar III measures: Useful but not sufficient by themselves 

The paper notes that the“Three Pillars” under prudential rules each play a role in making financial institutions resilient by ensuring associated risks are identified and taken into account by banks, insurers as well as regulatory and supervisory bodies. Measures under Pillar II (supervisory review of internal capital adequacy) and Pillar III (public disclosures to trigger market discipline) are useful and should therefore be pursued, but they are not able by themselves to thwart the risk of financial institutions being destabilised by the impact of climate change.

No Pillar II measure resulted in financial institutions building capital buffers for climate-related risks, the paper notes. On Pillar III, climate risk disclosures fail to tackle the risk because the economic role of prices is to reflect average future expected value of assets, not their value in case of extreme events.

Why it matters

The battle over coal and other fossil fuels took centre stage at the UN COP26, as climate change, “green swan” catastrophic events and a climate-related financial crisis loom.

Leading regulators, supervisors and researchers across the globe have spotted the link between climate change and financial stability. Meantime, financial institutions contribute to the acceleration of climate change by financing greenhouse gas-emitting activities, while impacted by devastating consequences wrought by climate-related events. Analyses by the Intergovernmental Panel on Climate Change (IPCC) and the International Energy Agency (IEA) warn of the devastating consequences of delaying action to reduce greenhouse gas emissions and call to immediately stop all investments in new fossil fuel assets or activities. Financial regulators and supervisors confirm that there are clear benefits for the financial sector of acting early. Applying quick and simple changes to prudential capital measures for banks and insurance companies could help tackle the challenge.