A Risky Bet: Climate Change and the EU’s Microprudential Framework for Banks

Abstract Banking regulation and supervision have a key role to play in realizing the EU’s climate change objectives. In this article, we analyse the EU-level initiatives currently underway to decarbonize the banking system, in particular with regard to the microprudential rulebook. We document how regulators work hard to fit climate policy into the existing objectives of the microprudential framework. We also assess whether these efforts are likely to be successful by sketching two ways forward, which involve their own distinct hazards. The first is a ‘Deferential Transition’, which sees policymakers rely on banks and external rating providers to develop adequate internal risk management procedures while taking a largely agnostic approach as to what methodologies are appropriate. If this is the way forward, we see a number of risks: banks have a clear incentive to downplay risk, while large financial institutions gain a significant advantage and the division of responsibility between banks and supervisors becomes blurred. We also outline the scenario of a ‘Guided Transition’, in which regulators provide fine-grained guidance on the future that banks should anticipate. Although we broadly think this approach is the more effective route to greening EU banking, we also see challenges of an entirely different sort: regulators will unavoidably face political choices and EU lawmakers will need to consider issues of legality, legitimacy, and accountability. In this regard, we argue, the EU faces a risky bet.