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Accounting for climate transition risk in banks' capital requirements

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Abstract

This paper uses a stylized simulation model to assess the potential impact of transition risk on banks' balance sheets and establishes a basis for calibrating relevant macro-prudential instruments. We show that even in the short run, a fire-sale mechanism could amplify an initially contained shock on high-carbon assets into a systemic crisis with significant losses for the EU banking sector. We calculate that an additional capital buffer of 0.5% RWA on average would be sufficient to protect the system. Moreover, under an orderly transition, the decrease in banks’ transition risk exposure due to the greening of the economy would reduce the effect of a fire-sale by a factor of 10.

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  • Alessi, Lucia & Di Girolamo, Francesca Erica & Pagano, Andrea & Petracco Giudici, Marco, 2022. "Accounting for climate transition risk in banks' capital requirements," Working Papers 2022-08, Joint Research Centre, European Commission.
    • Handle: RePEc:jrs:wpaper:202208
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    File URL: https://joint-research-centre.ec.europa.eu/publications/accounting-climate-transition-risk-banks-capital-requirements_en
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    More about this item

    Keywords

    Green transition risk; dynamic balance sheet; banking crisis;
    All these keywords.

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • G2 - Financial Economics - - Financial Institutions and Services
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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