Finance Seminar

Abstract: We study bank capital requirements as a tool to address financial risks and externalities caused by carbon emissions. Capital regulation can effectively address climate-related financial risks but doing so does not necessarily reduce emissions. For example, higher capital requirements for carbon-intensive loans exposed to transition risk may crowd out lending to clean firms. When it comes to affecting carbon externalities, capital requirements are inferior to carbon taxes: Reducing carbon emissions via capital requirements may require sacrificing financial stability or may be altogether infeasible. However, if the government is unable to commit to future environmental policies, capital requirements can make higher carbon taxes credible by ensuring banks have sufficient capital to absorb losses from stranded asset risk.