Capital Regulation as Climate Policy

Abstract

Federal banking regulators are grappling with how to confront the threats posed by climate change. There are increasingly loud calls for regulators to adjust the “risk-weights” used to calculate banks’ minimum capital requirements based on how exposed their counterparties are to climate-related risks. This action could safeguard the financial system, and potentially make it less desirable for banks to lend to carbon- intensive activities. But other scholars have challenged the legality and administrability of this proposal. They argue that it is difficult to gather reliable empirical data about climate-related risks, and that any risk- weights that are not grounded in such data impermissibly deviate from risk-weights’ intended purpose.

This Article argues that these counter-claims are wrong. It does so by challenging the widespread misconception of the nature and function of risk-weights. Risk-weights are unavoidably discretionary policy instruments. They cannot simply be set through mechanical calculations, and always reflect a trade-off between limiting risks to banks (counseling setting a higher risk-weight) and enabling them to extend credit to a given activity in the real economy (counseling setting a lower one). At times, this trade-off has been explicit; it is always implicit in the exercise of regulatory discretion.

Further, Congress’ delegation of authority to the banking regulators reflects this understanding of risk-weights. In light of the complex policy challenge of setting risk-weights, Congress gave the regulators wide discretionary authority—generally exempt from judicial review—to engage in negotiation and experimentation. Yet when Congress has disagreed with how regulators have negotiated the risk- weight trade-off, it has reversed their decisions without restricting the delegation of authority. It may well be difficult to isolate climate-related financial risks in setting risk-weights. But this is no obstacle to regulatory action needed to protect the safety and soundness of the financial system.

Keywords: financial regulation, climate change, banking law, administrative law, capital requirements, climate risk, Federal Reserve, risk and uncertainty

JEL Classification: G2, G21, G18, G32, Q5, Q51, Q54, Q58