Climate Change Regulations: Real Effects and Bank Lending

The financial system will be affected by climate risks and climate policies. In recent years, monetary authorities have required banks to include climate risks within their risk management systems, including their Internal Capital Adequacy Assess Process (the so-called ICAAP). Some policymakers are considering using prudential capital measures to redirect funds away from high-carbon activities into green sectors. However, the primary objective of prudential capital requirements to improve the stability and soundness of financial institutions is to do so. Whether climate-related prudential actions impact bank lending or athletic activity is still being determined. This question has important policy implications. Adverse effects on bank lending could indicate that banks cannot finance firms in climate-exposed industries due to the high costs of bank capital. Even though they might not be desired, such outcomes can be beneficial if they encourage the divestment of high-carbon activities. Limiting credit supply to firms that are highly exposed to climate change risk could be harmful as it might hinder their ability to finance the transition towards a more carbon-intensive economy.

We recently published Miguel and co., 2022. This paper examines a Brazilian policy that requires systemically essential banks with assets greater than 10% to include environmental risks in capital adequacy assessment. To investigate the impact of the guideline on bank lending, economic activity, and greenhouse gas emissions (GHG), we use bank lending data and a taxonomy that identifies environmentally sensitive sectors. The introduction of the 2017 ICAAP resulted in large banks transferring lending away from vulnerable sectors. Large banks also shifted in credit to vulnerable sectors, with a shorter loan maturity as short-term loans were more readily available to these sectors (see Figure 1). Banks exempted from the ICAAP exercise increased the total credit volume and the loan maturity to firms in the exposed sectors. We find that the expansion of credit by smaller banks to firms in the sensitive sector compensates for the decrease in honor by larger banks.

Figure 1. Figure 1. Lending results of large and small banks

We also examine whether exposed firms can switch lenders to substitute loans across banks fully or if they experience lower actual outcomes due to credit contraction. This includes their ability to reduce their carbon footprint. We use the Brazilian formal labor market census (RAIS) and comprehensive data on greenhouse gas emissions (The Greenhouse Gas Emission and Removal Eliminating System, SEEG). The policy has a moderate effect on actual economic activity. We find no differences in employment or total GHG emissions in municipalities where banks were most affected by the ICAAP exercise (treatment) compared to those with less exposure to systemically significant banks (control). However, there is evidence of labor reallocation between large and small firms within the exposed sectors. The results show a decrease in legal firms in municipalities treated by the policy while the average size of firms increases. In line with this finding, the employment share and the share of micro-firms in exposed sectors decrease after the procedure is implemented in large-banking municipalities. The evidence suggests that the decrease in credit available to environmentally vulnerable firms by systemically significant banks is partially offset by an increase in bank supply. The adverse effects of the credit contraction are concentrated in smaller businesses, which cannot substitute borrowing across banks.

Future Work and Policy Lessons

1. While the sharp decline in credit supply by large banks is partially compensated by banks not subject to the ICAAP exercise, it comes at the expense of increasing exposure to more environmentally sensitive sectors. Our setting shows the importance of protecting the whole financial system when taking climate-related prudential steps.
2. Although many firms are protected from the supply shock because they can swap credit with other lenders, adjusting bank portfolio adjustments to meet climate-related capital requirements could negatively impact borrowers with limited access to credit. The negative effect on financial inclusion is an unintended consequence that prudential measures should be closely monitored.
3. A multi-country study of the effects of climate-related capital would be a bold research goal. The Bank of England, European Central Bank, and other supervisory agencies have established guidelines for managing climate-related and environmental risks since 2020. It would be interesting to see if country-specific characteristics are a source of heterogeneity concerning the impact of climate capital requirements on credit supply.