Breaking the Climate-Finance Doom Loop

Financial regulators and supervisors have come far in recognising the threat climate change represents for financial stability. But their actions so far, useful as they are, have been focused mainly on transparency measures and stress tests. In the best of cases, more effective prudential interventions will take years to enter into force, by when the planet’s carbon budget will be nearly exhausted.The lack of prudential action so far is grounded in a paradox: policy-makers recognise the near-impossibility of modelling climate-related risks but say that they need such modelling to be done before intervening. Unfortunately, given the short time available, late action is equivalent to doing nothing.

The report calls for immediate regulatory action to end the climate-finance doom loop, in which fossil fuel finance enables climate change, and climate change threatens financial stability in unpredictable ways. It sets out a legal basis for applying higher risk weights to banks’ exposures to existing and new fossil fuel reserves using prudential tools already available in the Capital Requirements Regulation (CRR). This would dramatically increase the effectiveness of existing regulatory responses, which have so far focussed on transparency, risk modelling and scenario-based analysis.

Finance Watch’s recommendations to policy-makers:

1. Calibrate the risk weight for bank exposures to existing fossil fuel reserves at 150% in order to make it coherent with Article 128 of the Capital Requirements Regulation (CRR);
2. Calibrate the risk weight for bank exposures to new fossil fuel reserves at 1250% in order to make the financing of new fossil fuel exposures by banks entirely equity-financed to reflect both micro-prudential and macro-prudential risks;
3. Ensure that the modified risk weights are reflected in banks’ internal models for the purpose of calculating capital requirements;
4. Activate Article 459 of the CRR to take immediate action and implement the modified risk weights until banks’ prudential requirements for fossil fuel exposures have been amended in CRR;
5. Amend the risk weights for banks’ existing fossil fuel exposures in Article 128 of CRR and for banks’ new fossil fuel exposures in Article 501 of CRR;
6. Promote the adoption of similar prudential requirements globally by engaging the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB).