Climate Change Regulations: Bank Lending and Real Effects

The financial system will be greatly affected by climate threats and policies. Financial regulators have recently mandated that banks incorporate climate risks into their frameworks for managing risk, including in their so-called ICAAP—internal capital adequacy assessment process.

The primary goal of prudential capital requirements is to increase the soundness and stability of financial institutions, even if some policymakers are looking into the explicit use of prudential measures to divert money away from high-carbon industries and into green sectors. It has to be seen empirically whether recently imposed prudential rules relating to the environment impact bank lending and business activity. This has significant policy consequences.

For example, the adverse effects on bank lending imply that capital costs are associated with banks that limit their capacity to support businesses in areas vulnerable to climate change. Such results might be preferable, even if unanticipated since they encourage the cessation of some high-carbon activity. However, limiting financing availability to businesses exposed to high levels of climate change risk could be harmful since it limits their ability to finance the shift to a less carbon-intensive economy.

In a recent study conducted by Miguel et al. (2022), the authors investigate the impact of a 2017 policy implemented in Brazil, which required systemically important banks with assets exceeding 10% of the country's GDP to integrate environmental risks into their capital adequacy assessments. By analyzing bank lending data and employing a taxonomy of environmentally exposed sectors, the study examines the effects of this policy on bank credit, firms' economic activities, and greenhouse gas emissions (GHG).

Figure 1. Lending outcomes of small and large bank groups

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Notes: Panel A displays the monthly aggregate share of corporate lending of small and large banks channeled to the 332 5-digit sectors classified as exposed. Panel B displays the share of lending to exposed sectors by small and large banks that has maturity of one year or less.

The study also examines whether firms operating in environmentally exposed sectors have the ability to switch lenders and fully replace loans across different banks, or if the credit contraction they experience results in adverse real outcomes, including their capacity to reduce their carbon footprint. To investigate this, the researchers utilize the Brazilian census of the formal labor market (RAIS) and a comprehensive dataset on greenhouse gas emissions (SEEG - The Greenhouse Gas Emission and Removal Estimating System).

The findings suggest a moderate impact of the policy on real economic activity. Specifically, no significant differences were observed in the levels of employment and total GHG emissions among exposed firms in municipalities where the banks affected by the ICAAP exercise had a strong presence (treatment) compared to municipalities with less exposure to systemically important banks (control).

However, there is evidence of labor reallocation occurring within exposed sectors, specifically between small and large firms. The results indicate a decline in the number of formal firms and an increase in average firm size in treated municipalities. Correspondingly, the employment share and the proportion of micro firms within exposed sectors decrease after the policy in municipalities with a higher incidence of large banks.

Overall, the evidence suggests that the credit contraction experienced by systemically important banks in relation to environmentally exposed firms is largely compensated by increased lending from other banks. However, the negative effects resulting from the credit contraction seem to affect smaller firms more significantly, as they face greater challenges in substituting borrowing across different banks.

Policy Lessons and Future Work

1. The sharp contraction in the credit supply of large banks, is partially offset by banks not subject to the ICAAP exercise but at the cost of increased exposure to environmentally exposed sectors. The shift in exposure of environmental risks from large to small banks in our setting highlights the importance of safeguarding the entire financial system when implementing climate-related prudential measures.

2. While many firms are insulated from the supply shock (as they can substitute credit across lenders), adjustment of bank portfolios in response to climate-related capital requirements may disproportionally affect borrowers that typically have limited access to credit, such as SMEs. An unintended consequence of prudential measures that should be closely monitored is the negative impact on financial inclusion.

3. An ambitious research agenda would be to study the impact of climate-related capital in a multi-country setting. Since 2020, the Bank of England, the European Central Bank, and other supervisory agencies have introduced guidelines to climate-related and environmental risk management.