Fat Tails, Tipping Points and Asymmetric Time Horizons: Dealing With Systemic Climate-Related Uncertainty in the Prudential Regime

Abstract

Climate-related financial risks (CRFR) pose unique challenges for capital requirements regulation. CRFR are forward looking, non-linear, systemic and endogenous – attributes that render quantitative estimates of physical and transition risk subject to radical uncertainty. CRFR are also characterised by asymmetric time horizons: the worst impacts will emerge over the long term but the trajectory of future scenarios is endogenous to actions taken in the nearer term. Even pioneering forward-looking stress tests cannot feasibly capture all possible tail risks. We propose supplementing the existing capital requirements regime by giving it a stronger precautionary and macroprudential focus, paying particular attention to the prevention of environmental tipping points to avoid systemic and catastrophic impacts on the financial system and macroeconomy.

Three complementary interventions are proposed. Firstly, classifying new and existing fossil fuel exposures as higher risk within the Pillar 1 framework would help address the systemic underpricing of CRFR in the most sensitive asset classes for all regulated financial institutions. Secondly, to explicitly deal with the time horizon-, systemic risk and endogeneity challenges, we propose a new Pillar 4 be introduced. This would dynamically tie prudential policy to the net-zero carbon transition via the imposition of variable capital risk weights on all fossil fuel-related assets, reflecting the global ´overshoot´ from a safe carbon budget within a 1.5C scenario. Thirdly, a climate systemic risk buffer could be applied to those institutions with the largest exposures to CRFR. This would both enhance financial system resilience and internalise the systemic risks created by such institutions.

To successfully implement such reforms would require closer attention to the measurement and disclosure of negative environmental impacts by financial and non-financial firms as a proxy for the assessment of CRFR. Greater policy coordination between financial supervisors, ministries of finance and other relevant government agencies would also support a more strongly climatealigned capital regime.

Keywords: capital requirements, climate-related financial risks, precautionary apporach, uncertainty, systemic risk buffer, Basel framework

JEL Classification: E58, G18, G28, Q50, Q54, Q58