A Risky Bet: Should the EU Choose a microprudential or a Credit Guidance Approach to Climate Risk?

Abstract

Banking regulation and supervision have a key role to play in realising the EU’s climate change objectives. In this article we analyse the EU-level initiatives currently underway to green the banking system, in particular with regard to the microprudential rulebook. We document how regulators work hard to fit climate change concerns into the existing objectives of the microprudential framework. We also assess whether these efforts are likely to be successful by sketching two ways forward, which involve their own distinct hazards. The first is a predominantly microprudential approach which sees policy-makers take action to force banks to develop adequate internal risk management procedures while taking a largely agnostic approach as to what methodologies are appropriate. If this is the way forward, we see a number of risks: banks have a clear incentive to downplay risk, while large financial institutions gain a significant advantage and the distribution of responsibility between banks and supervisors becomes blurred. We also outline a second “credit guidance” approach, in which regulators provide fine-grained guidance on how banks should evaluate climate risk. Although we broadly think this approach is the more effective route to greening EU banking, we also see challenges of an entirely different sort: regulators will unavoidably face political choices and EU lawmakers need to consider issues of legality, legitimacy and accountability. In this regard, we argue, the EU faces a risky bet.

Keywords: sustainable finance, prudential regulation, banking supervision, European Banking Authority, taxonomy, climate change risk

JEL Classification: G15, G18, G21, G32, K23