The rising tide of climate finance - scope to adjust prudential treatment

The interconnection between the climate change crisis and environmental degradation presents an urgent need for economies and businesses to transition towards more sustainable practices. This transition is essential not only to mitigate climate change but also to slow or reverse environmental degradation. For this shift to take place, substantial climate finance is required. A significant portion of this financing will need to come from the private sector, particularly from financial institutions such as banks, asset managers and investors.

As the demand for climate finance grows, a transformation in the financial sector is expected. Financial institutions' engagement in this transition will largely depend on their financial soundness as well as on the availability of resources and the incentives in place to make such involvement worthwhile. Arguably, institutions' solvency, resources and incentives are all dependent on the policy framework. Consequently, a key question arises: how can policymakers and regulators develop frameworks and policy measures that support financial institutions' involvement in climate finance while still addressing the risks posed by those activities on their safety and soundness?

Within their mandates, central banks and supervisors have a variety of policy options at their disposal to discharge their traditional financial stability and safety and soundness mandate, anticipating the increased exposure of financial institutions to climate-related financial risks. They may even adopt a more proactive stance, directly supporting a smooth transition process on grounds that transition risks can threaten the safety and soundness of financial institutions and the financial system. Those actions require the review of the existing regulatory and prudential toolbox, which may not capture the specificities of climate-related risks and opportunities.

It is crucial that financial regulations remain adaptable and fit for purpose as financial institutions' risk profiles evolve. As financial institutions engage more deeply in climate transition finance, their exposure to risks associated with climate change will change. Regulatory frameworks must be designed to accommodate these shifting risk profiles. This will facilitate a smooth transition that both supports financial stability and mitigates the pressing climate and environmental challenges.

JEL classification: G18, G21, G28, Q28

Keywords: climate change, banking supervision, climate finance