Capital regulation in the presence of climate risk

Abstract

We study optimal capital regulation in the presence of physical climate risk in the banking model with deposits mispricing. Physical climate risk is endogenous and can be reduced with more low yielding green investment. We show that bank deposits mispricing provides a subsidy encouraging green investment. Universal capital requirement for green and brown investment reduces the subsidy and cannot achieve the social optimum. It must be set higher in the presence of carbon tax to ensure financial stability. However, imposing brown capital surcharge and higher minimum capital requirement achieves the social optimum without hampering financial stability. Higher carbon tax requires then lower optimal brown capital surcharge.

Keywords: bank capital regulation, physical climate risk, deposit insurance, free riding, financial stability, public good