Climate Transition Risk and The Role of Bank Capital Regulation

Abstract

How should capital requirements be set to deal with climate-related transition risks? We assess the role of bank capital regulation in mitigating carbon tax spillovers into the financial sector employing a general equilibrium macro-finance model. Production in our model requires intermediate, fossil, and clean energy inputs. The banking sector provides specialized credit to each intermediate industry and is subject to standard limited liability frictions. In the medium run, higher capital requirements for banks' fossil exposures are welfare superior to general capital requirements and indirectly support a green credit transition. The economy's capacity to substitute fossil for low-carbon energy production inputs determines the complementarity between bank capital regulation and carbon tax policies in supporting a green credit transition. Our transitional dynamics analysis indicates that increasing fossil capital requirements to their optimal medium-run level delivers long-run welfare gains at the expense of short-run losses.

Keywords: DSGE, climate risk, financial intermediation, macroprudential policy, default risk

JEL Classification: Q43, D58, G21, E44