Climate change could give fiddling with bank capital a good name. Regulators have spent much of the last decade trying to stop lenders massaging their solvency to boost returns. Yet that same sleight of hand could make a big difference in the fight against global warming.
The main job of prudential regulators is to stop lenders going bust. They do this by ensuring banks hold enough equity capital relative to their loans, weighted according to how risky they are. These risk-weighted assets (RWAs) calculations appear highly mechanistic. Each loan is adjusted according to chances it will go bad, and how much the bank will recover if it does. This is based on decades of historical data. Assuming the regulator approves, the formula determines the minimum amount of capital a bank must maintain.
In practice, RWA calculations are intensely political. In the euro zone, for example, sovereign bonds issued by member states famously had a risk-weighting of zero, encouraging banks to load up on government debt which proved anything but risk-free.
Climate change-conscious regulators like the Bank of England are pondering how this system can help fight climate change. There are two considerations: first, historical data is a poor guide to whether loans sour in future because of global warming. Second, tilting the scales could encourage the financial system to favour projects which help avoid a catastrophic outcome.