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Minimum capital requirements: the cornerstone to tackling climate risk

Sustainable finance

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New report says regulatory and supervisory actions taken to date are not sufficient on their own to ensure resilience of the financial sector against climate-related financial risks.

  • While supervisors and financial institutions continue to build understanding of climate-related financial risks and appropriate mitigation tools, they also recognise the benefits of acting early
  • Climate-driven  financial crises can be thwarted if climate-related financial risks get inserted ‘without delay’ into EU bank and insurance prudential capital rules.
  • As wider work on an array of prudential measures continues, quick fixes to capital rules can address risks climate change poses on the financial system. The EU CRR/CRD and Solvency II review opens a window to act now and demonstrate global leadership.

BRUSSELS, 24 November 2021 – As a battle over coal and other fossil fuels took centre stage at last week’s UN COP26, climate change, “green swan” catastrophic events and a climate-related financial crisis loom. Applying quick and simple changes to prudential capital measures for banks and insurance companies would go a long way in tackling the challenge.

A new paper written by Finance Watch deduces the best solution among different prudential tools and the results achieved so far in tackling climate-related financial risks (CRFR). It concludes the silver bullet lies in minimum capital requirements for financial firms who finance fossil-fuel companies and projects. Titled “A silver bullet against green swans: Incorporating climate-related financial risk into bank and insurance prudential rules”, it states the change would force banks and insurance firms to seek out and address CRFR and build up more capital to absorb inevitable losses brought by events stemming from those risks.

Author Julia Symon notes: “Prudential quick fixes like higher capital requirements for fossil fuel financing prove the most effective option currently available. None of the existing measures have come close to yielding tangible results in managing the CRFR.

“Under the first  pillar of prudential rules, minimum capital requirements can be differentiated based on risk for any new and existing fossil fuel plays. In particular, for new fossil fuels, a ‘one-for-one’ rule or full-equity financing should be applied.”

Capital requirements matching climate risk profile: A precautionary approach

Implementing one-for-one capital requirements for the financing of new fossil fuels means 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.

Symon added: “Capital remains the most impactful tool to address climate-related risks by acting as a buffer to absorb losses in crisis situations. A feasible measure, capital rule changes  can be implemented without further delay using existing prudential tools.

“European regulators must not miss the opportunity to adjust capital requirements in the current review of the banking (CRR/CRD) and insurance (Solvency II) prudential rules.”

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.

Symon added: “Within Pillar III, disclosing information will not suffice to ensure resilience of financial institutions against climate-related events. As long as climate-related risk remains underpriced, financial institutions´ incentives to finance fossil fuels will hardly change.”

Why Pillar I prudential measures matter

Leading regulators, supervisors and researchers across the globe have spotted the link between climate change and financial stability. Meanwhile, 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.

Symon concluded:  “Time is ticking. Policymakers must enact Pillar I changes to ensure financial sector resilience and its ability to support the economy down the road.

“The focus on ‘softer’ prudential measures under Pillar II and III runs the risk of slowing the process for action that brings real impact. Following that route exclusively  without beefing up Pillar I would mean repeating mistakes that led to the 2008 financial crisis.”

Read the paper


Notes to editor:

About Finance Watch

Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.

Report – Breaking the climate-finance doom loop

https://www.finance-watch.org/publication/breaking-the-climate-finance-doom-loop/

Finance Watch publication “Insuring the Uninsurable” published in July 2021 and related press release

https://www.finance-watch.org/publication/insuring-the-uninsurable/

EU Banking Package 2021: Finance Watch comments, October 2021

https://www.finance-watch.org/press-release/finance-watch-comments-on-the-eus-banking-package-2021/

Finance Watch statement in response to the publication of the European Commission ‘Strategy for Financing the Transition to a Sustainable Economy‘, July 2021

https://www.finance-watch.org/press-release/europe-needs-a-more-ambitious-sustainable-finance-strategy/

Letter sent to EU policymakers on the climate-finance doom loop, May 2021

https://www.finance-watch.org/publication/letter-to-eu-policymakers-to-close-climate-finance-doom-loop-through-crr-solvency-ii-upgrades/

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