Accounting for climate risk in capital requirements: Mitigate risks, identify opportunities, and drive higher returns for banks
Banks are required to report on various risk factors that affect the quality of their asset bases—risk-based capital requirements. We believe it’s time for banks to consider climate or carbon risk in these analyses. As the world moves toward net-zero and potentially faces climate-related events such as forest fires and floods, the costs of decarbonization and climate risk should be included in assessments and minimum capital requirements. Indeed, without these considerations, banks could be underweighting the riskiness of their assets in their capital adequacy reporting—and less prepared to deal with climate-related market shocks.
The risks of not counting carbon risk
Both Basel III and Dodd-Frank regulations require banks to calculate minimum capital requirements based on risk-weighted assets (RWA). Under RWA, riskier assets such as equity investments are given a higher risk weight than less risky assets such as cash.1,2 As the riskiness of a bank’s portfolio increases, the minimum required capital increases and the bank is left with less capital to invest or lend. The current approach to minimum capital requirements fails to take into consideration climate or carbon risks.
Calculating carbon risk can also help the bank mitigate the risks to the business from climate change. These risks may overlap and create compounding losses for banks because the underlying climate or carbon risk of assets is not considered within the standard approach to risk budgeting. For example, a bank with significant exposure to carbon-intensive businesses (as investments and customers) faces market and economic risks from fossil-fuel price hikes and consumer behavior changes, technology risks from the introduction of low-carbon innovations, policy and legal risks from new climate-risk regulations, and reputational risks associated with all these risk factors.
The benefits of counting carbon risks
By taking climate or carbon risk into account when shaping enterprise-wide risk programs, banks can mitigate the risks listed above. For example, by accurately gauging the level of climate or carbon risk in their lending and investment activities, banks can better manage future climate-related macro events. The latest report from the Intergovernmental Panel on Climate Change3 makes clear that financial intermediaries like banks must play a key role in lowering the funding gap to reach global net zero goals.
To accomplish this, banks may need to be more stringent in how they assess key risks that are not now completely assessed: their ongoing investment in carbon-intensive companies and new investments in emerging green or low-carbon firms, for example.
Carbon asset risk, in particular, may be underrepresented in current loan or investment portfolios, because operators of carbon-intensive assets could be mismanaging risks and opportunities associated with climate transition activities and thereby skewing the risk/return profile negatively.4
By assessing, quantifying, and integrating climate or carbon risk weights into the standardized RWA process and capital requirements, banks may be able to more accurately gauge the overall riskiness of their portfolios, mitigate climate risks, identify new opportunities, and ultimately drive higher returns.
Calculating climate risk
How can banks account for the impact of climate risk? It can be done with respect to microprudential and macroprudential approaches. This chart lays out the adjustments that can be made.
Climate risk adjustments | |
| Climate systemic risk buffers | Banks hold additional capital if they have significantly high exposure to assets that possess high physical or transition risks. |
| Carbon-intensive leverage ratio | Banks with a certain level of carbon-intensive assets would be required to have a higher level of Tier 1 capital. |
| Carbon-intensive countercyclical capital buffer | Banks would be required to hold more capital when the carbon-intensive credit-to-GDP ratio is higher than its trend based on their exposure to carbon-intensive assets. |
| Replacement risk weights | Replacing the risk weight of assets based on their level of exposure to climate-related physical or transitions risks. Finance Watch has proposed that new fossil fuel projects carry a 1,250 percent risk weight. |
| Green differentiated capital requirements | Using a green supporting factor to reduce the risk weight on green loans and the dirty penalizing factor or brown penalizing factor to increase the risk weight on dirty loans. |
| One-for-one | One-for-one: Bank would be required to hold an equivalent amount of capital for each loan unit provided to fossil fuel projects. |
Source: “Greening capital requirements,” Inspire Sustainable Central Banking Toolbox, Policy Briefing Paper No.8
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