Accounting for climate transition risk in banks' capital requirements

Abstract

This paper uses a stylized simulation model to assess the potential impact of climate transition risk on banks' balance sheets in a climate-stress-testing (i.e. short-run) framework. We show that a moderate to high transition risk increases overall bank losses only relatively modestly if the baseline is a stressed macroeconomic scenario. However, even in a benign macroeconomic scenario, if high-carbon assets are at least 13% riskier than comparable assets a fire sale mechanism could amplify an initially contained shock into a systemic crisis, resulting in significant losses for the EU banking sector. We show that transition risks are concentrated, and find that an additional capital buffer of 0.9% risk-weighted assets on average would be sufficient to protect the system.

Keywords: Banking crisis; Climate stress-testing; Climate transition risk; Dynamic balance sheet.

Fig. 1

Summary of inputs for the estimation of transition risk exposures on banks’ balance sheets.

Fig. 2

Share of assets exposed to transition risk: red line refers to FFA-related assets and the blue line refers to mortgages for energy-inefficient buildings.

Fig. 3

Distribution of increases in RWA due to exposure to transition risk.

Fig. 4

Description of the empirical analysis.

Fig. 5

Distribution across countries of loss increases in percentage terms (left panel) and of losses as a share of TA (right panel) for $\beta =13\text{\%}$.

Fig. 6

Calibration of $\beta$, representing increased riskiness of high-carbon assets; the graph shows the size of losses under each value of $\beta$.

Fig. 7

Calibration of $\delta$, representing the initial depreciation; the graph shows the size of median losses under each value of $\delta$.

Fig. 8

Evolution of the fire sale in terms of cumulative share of banks at default (left panel) and cumulative share of bank losses as a share of TA (right panel), under different levels of sell-off (light blue sell-off is equal to 0%; dark blue sell-off is equal to 16%).

Fig. 9

Distribution across banks of losses as a share of TA, after a fire sale and under different levels of initial sell-off.

Fig. 10

Distribution across banks of additional capital needed to offset transition risk, as a share of RWAs.

Fig. 11

Parameters’ space for bonds, equity and penalizing factor.

Fig. 12

Effect of bond and equity uncertainty on the model output.