Environment – risk-weighted assets: allowing banking supervision and green economy to meet for good

The 2008 crisis exposed the not-so-benign neglect of systemic risk and financial stability in theoretical analyses as well as in economic and regulatory policies. As the world financial crisis was unfolding, we have also seen a growing awareness of another threat to the world economy: climate change. A connection is emerging between the two aspects with the development of the ‘green and sustainable finance’ paradigm as an essential part of the Paris Agreement on climate change and of the needed transition to a low carbon and green economy. We propose redesigning banking prudential regulation to take into account the environmental dimension of banks riskiness as an additional component of the current prudential framework, based on the calculation and gradual implementation of pollution-based risk coefficients for capital requirements. We present the main methods and suggest practical approaches to develop them. Finally, we test our proposal using available data for Italy, showing how the tool can help to push the banks’ to take into account the environment dimension in their credit policies without disrupting the banking system.