SOAS Research Online

Abstract

Capital requirements play a central role in financial regulation and have significant implications for financial stability and credit allocation. However, in their existing form, they fail to capture environment-related financial risks and act as a barrier to the transition to an environmentally sustainable economy. Environmental issues can be incorporated into capital requirements using three different approaches: (i) microprudential approaches, which suggest that capital requirements need to be adjusted based on micro-level exposures to environmental risks; (ii) weak macroprudential approaches, which emphasise the exposure of financial institutions to systemic risks linked to specific sectors and geographical areas; and (iii) strong macroprudential approaches, whereby systemic risks are analysed by explicitly considering macrofinancial feedback loops and double materiality. In the age of environmental crisis, strong macroprudential approaches should play a prominent role in the greening of capital requirements. Green differentiated capital requirements (GDCRs) are one of the tools that are consistent with a strong macroprudential approach. If designed to accurately capture the environmental footprint of bank assets and minimise adverse financial side effects, GDCRs can contribute to the greening of the banking system and the reduction of physical risks. The positive effects of GDCRs can be enhanced if they are combined with other financial and non-financial environmental policy tools.