Accounting for climate transition risk in banks' capital requirements

This paper uses a stylized simulation model to assess the potential impact of transition risk on banks' balance sheets and establishes a basis for calibrating relevant macro-prudential instruments. We show that even in the short run, a fire-sale mechanism could amplify an initially contained shock on high-carbon assets into a systemic crisis with significant losses for the EU banking sector. We calculate that an additional capital buffer of 0.5% RWA on average would be sufficient to protect the system. Moreover, under an orderly transition, the decrease in banks’ transition risk exposure due to the greening of the economy would reduce the effect of a fire-sale by a factor of 10.