This report advances a strategy for integrating climate risk into the capital framework—a strategy that deploys the type of cautious approach to financial stability that justifies vigorous and proactive action now, while acknowledging that some additional valuable—but more intricate—policies may take longer to develop and implement. Specifically, there are five capital-related steps financial regulators should take to mitigate climate-related financial risks:
- Adjust capital risk weights for bank exposures that face acute transition risks.
- Implement a macroprudential climate risk contribution capital surcharge.
- Establish long-term climate stress tests and add near-term climate variables to existing stress tests.
- Integrate additional transition risks and physical risks into capital risk weights.
- Follow climate risks into the shadow banking sector.
The author concludes that it is critical for financial regulators to aggressively mitigate the risks that climate change poses to the financial system. Regulators would be neglecting their mandates and statutory obligations if they choose to ignore these risks and let them fester. While there are a range of policy tools that should be utilized to safeguard the financial system from climate-related risks, the capital framework is a core element of banking regulation and should be a cornerstone of these efforts.