The Next Big Financial Crisis Could Be Triggered By Climate Change – But Central Banks Can Prevent It

A second policy proposal is to modify existing regulations to recognize the risks that climate change poses to banks. Banks are usually subject to minimum capital requirements to ensure banking sector stability and mitigate the risk of financial crises. This means that banks must hold some minimum amount of liquid capital in order to lend.

Incorporating environmental factors in these requirements could improve banks’ resilience to climate-related financial risks. For instance, a “brown-penalizing factor” would require higher capital requirements on loans extended to carbon-intensive industries, discouraging banks from lending to such industries.

Broadly, these existing proposals have in common the goal of reducing economy-wide carbon emissions and simultaneously reducing the financial system’s exposure to carbon-intensive sectors.

The Bank of Japan announced a new climate strategy on July 16, 2021, that includes offering no-interest loans to banks lending to environmentally friendly projects, supporting green bonds and encouraging banks to disclosure their climate risk.

The Federal Reserve has begun to study these policies, and it has created a panel focused on developing a climate stress test.

Lessons from economists

Often, policymaking trails scientific and economic debates and advancements. With financial regulation of climate risks, however, it is arguably the other way around. Central banks and governments are proposing new policy tools that have not been studied for very long.

A few research papers released within the last year provide a number of important insights that can help guide central banks and regulators.

They do not all reach the same conclusions, but a general consensus seems to be that financial regulation can help address large-scale economic risks that abruptly introducing a climate policy might create. One paper found that if the climate policy is implemented gradually, the economic risks can be small and financial regulation can manage them.

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Disclosure: This article is republished from The Conversation under a Creative Commons license.

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