Finance quantitative

• Climate change risks and the of capital bank requirements:

INTRODUCTION

In light of the growing urgency to combat climate change, governments and institutions are implementing policies to reduce carbon emissions. A major challenge is that these policies, particularly carbon taxes, pose transition risks for the banking sector due to increased volatility in energy prices and potential financial spillovers. This paper, by Salomon Garcia-Villegas and Enric Martorell, examines how banking regulations—specifically capital requirements—can serve as a buffer against these risks, preserving financial stability during the transition to a low-carbon economy. This context situates the study within the intersection of climate policy and macroprudential regulation, an area increasingly significant to policymakers​.

Objective and Problem Statement

The paper aims to explore whether sectoral capital requirements can effectively mitigate financial risks arising from climate policies and support a stable transition. The core problem revolves around managing increased risks in banking from climate-related energy price fluctuations, particularly those driven by carbon tax policies. The study’s objectives are threefold:

1. Investigate if capital requirements can stabilize the banking sector against climate policy-induced risks.
2. Assess if capital requirements alone can act as a climate policy tool.
3. Examine the effects of combining carbon taxes with capital requirements along the equilibrium transition path to achieve climate goals?

Hypothesis

The authors hypothesize that sectoral capital requirements—targeted adjustments based on the risk exposure of banks to energy sectors, can better manage financial stability risks and indirectly facilitate a green credit transition compared to uniform capital requirements. By examining this in a DSGE framework, they posit that sectoral adjustments will more effectively mitigate risk spillovers from carbon tax impacts than general increases in capital requirements.

Significance of the Research

This research question is pertinent as it bridges macroprudential regulation with climate policy, potentially reshaping the role of financial institutions in climate adaptation. Understanding how capital requirements can support financial stability under climate policies is crucial, especially as banks are key financiers of both fossil and low-carbon sectors. The study's findings could influence regulatory approaches, making it possible for financial systems to actively support climate goals while minimizing economic disruption​.

Presentation of the Results

The study finds that sectoral capital requirements, when set to reflect specific climate risks, perform better than uniform requirements in preserving banking sector stability and reducing spillover effects. Importantly, these requirements, when combined with carbon taxes, support a green credit transition by reallocating capital from fossil to low-carbon sectors. These findings support the hypothesis that sectoral capital requirements can achieve welfare gains and financial stability more effectively during the transition​.

Relation to Existing Literature

The paper contributes to existing DSGE-based studies on climate finance, extending work on macroprudential tools by integrating climate risk into financial regulations. While other studies have explored the impacts of reserve requirements (Campiglio, 2016) or climate-risk adjusted operations (Böser & Colesanti Senni, 2021), this research uniquely addresses climate transition risk through sectoral capital requirements. It builds upon earlier models that address bank failure risks and leverages studies showing energy price shocks' negative impacts on banks, contributing novel insights on the synergy between capital regulation and carbon tax policies​.

METHODOLOGY (ADD Mathematical relation and calibration methodology)

Sample Description

This study uses a Dynamic Stochastic General Equilibrium (DSGE) model rather than empirical sampling data to examine how bank capital requirements affect financial stability under climate transition risks. The sample in this model comprises households, firms in the energy and non-energy sectors, and a financial sector represented by banks that invest in these sectors. Specifically :

• Individual Dimension: The DSGE model includes representative agents, with households supplying labor to production sectors and holding deposits in banks. The banking sector finances fossil and low-carbon energy firms, each subject to distinct capital requirements.
• Temporal Dimension: The model simulates responses over a medium-to-long-term timeframe, aligning with anticipated decades-long transitions to a low-carbon economy.
• Data and Calibration: Calibration parameters are derived from European data sources, setting foundational assumptions based on past studies (e.g., Mendicino et al., 2020). For instance, bank failure rates and deposit insurance ratios align with Eurozone data​.

This structure allows for a robust and theoretically sound exploration of sector-specific risks in banking under carbon tax policies. Representativeness of this theoretical sample lies in its focus on core dynamics within the Eurozone banking sector, which captures the systemic impact of climate transition risks.

Model Specification

The DSGE model employed incorporates sector-specific banks with risk exposure to energy prices, based on extended frameworks from Clerc et al. (2015) and Mendicino et al. (2020). This model allows for a detailed analysis of how carbon tax policies impact financial stability, highlighting the role of both sectoral and general capital requirements.

Variables Defined

1. Dependent Variable: The bank failure rate is the primary outcome of interest, capturing how different capital requirement strategies influence bank stability across sectors. This rate reflects the probability of bank defaults due to volatility in energy prices, which increase under carbon tax scenarios.
2. Variable of Interest: The capital requirements—both general and sectoral—are the primary variables that adjust to manage transition risks. Specifically :

• General capital requirements apply uniformly across all banks, establishing a baseline risk buffer.
• Sectoral capital requirements are adjusted specifically for banks with exposure to carbon-intensive sectors, expected to provide more resilience against sector-specific risks.

1. Control Variables: These include energy prices, household deposits, and sector-specific production inputs, which influence lending dynamics within the economy. These controls enable isolation of the effect of capital requirements on bank failure rates​.

Expected Signs and Assumptions

• The expected sign on the capital requirement variable for fossil-sector banks is negative regarding bank failure rates: higher capital requirements should reduce the probability of failure by increasing banks' resilience to energy price volatility. For low-carbon sectors, the capital requirements are expected to encourage lending toward sustainable projects, contributing positively to the green credit transition.
• Key Assumptions:

• Uniform Initial Risk Levels: Banks begin with homogeneous risk profiles to isolate the effects of carbon policy-induced energy price shocks.
• Deposit Insurance: A portion of bank deposits is insured, reducing depositor risk and allowing banks to leverage more capital.
• Energy Price Elasticity: The model assumes symmetrical energy price risk across fossil and low-carbon sectors, enabling a consistent evaluation of carbon tax impacts​.

This setup allows the authors to assess how calibrated adjustments to capital requirements can stabilize banks under climate transition policies, thus providing policy insights for the Eurozone’s financial regulators.

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