On July 22-23, the G20 Finance Ministers and Central Bank Governors will meet in Brazil. This meeting provides a crucial opportunity to advance discussions and ideally set new guidelines on financing the transition and managing increasing climate risks. Beyond monetary policies, central banks have a powerful tool at their disposal: macroprudential policies.
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Macroprudential Policies
Today, credit is the primary financing channel for the economy in Europe and Italy, making it the most significant potential source of sustainable finance. However, green loans still represent a marginal portion of European banks’ loan portfolios, approximately 4-5%. At the same time, empirical evidence shows that European banks are excessively financing activities, sectors, and companies that are not aligned with climate goals. This creates a high exposure to risks relative to their capitalization, threatening their future solvency.
In this context, prudential regulation can be a decisive lever to redirect significant flows of credit and financial investments away from the fossil economy, in line with the COP28 commitments in Dubai, and towards supporting the ecological transition.
The Basel Accords
The entire architecture of prudential supervision over banking systems stems from the Basel Accords, developed by the Basel Committee on Banking Supervision (BCBS). Established in 1974, the BCBS comprises representatives from the banking supervisory authorities of 27 countries and operates under the Bank for International Settlements (BIS). This makes the position of G20 Finance Ministers and Central Bank Governors critical.
The BCBS issues guidelines, recommendations, and standards that do not directly impact the legal frameworks of participating countries. However, through the Committee’s recommended regulations, coordination and convergence among international supervisory regulations and procedures for banking system stability are achieved. The Basel framework has evolved over time, with the latest version, “Basel III,” consisting of three pillars:
- Capital requirements.
- Supervision and risk management.
- Market discipline through transparency and disclosure standards, allowing investors and depositors to assess each bank’s actual level of risk.
Risks assessment
While the ongoing process of integrating climate risks encompasses almost all aspects of the second and third pillars, integrating these risks into the first pillar—defining quantitative criteria for capital requirements and risk assessment methodologies—remains complex and controversial. Supervisory authorities resist this integration due to the methodological challenges of capturing climate risks with standard risk metrics. The real issue is translating the impacts (both direct and indirect) that financed entities have on the environment into metrics of actual risk for the financing bank, making capital requirements a tool to shift bank credit towards ecological transition.
Single and double materiality
Currently, risk assessment focus on the damages and losses that climate can cause to financial institutions (“single materiality”), not on the harmful impacts that institutions’ activities can have on the external environment (“double materiality”). The principle of “double materiality” is central to classifying climate impacts and underpins the European Green Deal and Taxonomy policies. Despite this, prudential regulation is currently designed around “single materiality.”
Adopting a “double materiality” approach also in the first pillar of Basel would require a shift in perspective: recognizing capital requirements as a tool to direct credit flows towards decarbonizing the economy, not just to protect individual banks’ assets.
This does not necessarily mean abandoning the current approach but rather requalifying it with a systemic perspective. The difficulty of capturing climate risks at a micro-analytical level and recognizing their systemic nature finds a more appropriate response in macroprudential measures. These measures acknowledge that systemic risks are endogenous to the system, stemming from collective economic agents’ behaviors, and aim to control and guide those behaviors to prevent their emergence. From a macroprudential perspective, relevant risks include not only those impacting individual institutions from external sources but also those that individual institutions help generate or amplify.
Climate and credit risks
Climate risks, like all systemic risks, are generally underestimated and require the application of aggregate correction factors linked to indirect indicators of potential exposure. Consequently, macroprudential regulation can no longer ignore the role of the financial system, particularly banks, in combating climate change. To safeguard system stability threatened by climate risks, it must instead become a policy tool at all levels.
From a macroprudential policies viewpoint, it makes sense to consider not only a selective increase in capital requirements to protect against risks (based on the bank’s concentration in risk sectors/areas) but also an instrumental increase in “solvency ratios.” These should be linked to aggregate indicators of the carbon footprint and total emissions of the entities financed by the bank (e.g., indicators required by non-financial disclosure regulations). Preferably, this should include forward-looking indicators ensuring the alignment of individual financed companies’ decarbonization plans with climate goals.
Empirical evidence shows that capital requirements significantly influence both the volume of credit and the level of bank interest rates, playing a crucial role in mitigating transition risks arising from aggressive decarbonization policies. These findings indicate that macroprudential policies are a necessary complement to climate policies, reducing financial intermediaries’ risk exposure. Without adequate capital requirements, these intermediaries amplify systemic risks.
Specific simulations also show that the combined implementation of “brown penalizing factors” (BPF) for high-emission sectors/companies and “green supporting factors” (GSF) for green sectors/companies helps banks reduce exposure to transition risks while mitigating adverse credit rationing effects, thereby supporting sustainable investments.
The critical role of the G20
G20 Finance Ministers and Central Bank Governors have significant power in determining societies’ present and future climate risk exposure. They should recommend that the Basel Committee and supervisory authorities adopt differentiated capital requirements for banks, harmonized internationally, with a clear framework for their application. Specifically:
- Develop a conceptual map linking Taxonomy sustainability criteria to a grid of systemic risk potential for financial activities, considering both current carbon footprints and forward-looking decarbonization plans.
- Calibrate and prescribe parameters for increasing or decreasing capital requirements aligned with this systemic risk grid.
- Indicate standardized and certified methodologies for evaluating the alignment of decarbonization plans with European Union and Paris climate goals.
- Establish binding monitoring procedures and impact targets consistent with the above points.
- Integrate control and reporting procedures with those already in place under the second and third pillars.
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Photo by Ibrahim Boran
