Prudential Regulations for Greening the Financial System: Coping with Climate Disasters

Prudential financial regulators, central banks, and regulatory authorities have increasingly come to recognize that they have a role to play in dealing with climate change. This should not be surprising, considering the extent to which finance plays a role in the everyday life of any society. By the same token, small changes in financial regulation should be expected to have a large impact on financial flows and hence on the real economy. Again, this should not be surprising, since financial regulations are designed to have a large leverage effect.

In a new journal article published by the Latin American Journal of Central Banking, Daniel M. Schydlowsky, former Chief Financial Regulator of Peru (2011-2015), examines the prudential regulations for greening the financial system while coping with climate disasters.

There are technical reasons why it is appropriate for the financial regulators to have concern and responsibility for responding to issues of climate change. First, climate change involves a massive externality. Second, when a climate disaster is involved, there is an externality with acute effects. Third, it is well established that individual, decentralized decisions in the face of externalities are most likely to be suboptimal. Fourth, in response to the massiveness of climate change, an answer is needed that can permeate the whole economy. Finance permeates the economy, and therefore financial regulation is such a response. Fifth, the response needs to be actively managed. The financial regulators are equipped to do precisely that.

Early efforts to relate climate issues to finance and regulation centered around creating markets for carbon credits and green bonds. At a later stage, interest developed in understanding the consequences of climate change for the financial system, especially banks and insurance companies, by focusing on issues such as sequestered assets resulting from needed changes in the structure of production and, hence, in the mix of assets financed. In these instances, the concern has been to identify the effect of changes in the real economy on the financial sector, with a view to ensuring that the financial system continues to be safe and sound, which is a concern consistent with the core responsibility of financial regulators. Only more recently has interest developed about the potential for financial regulation to actively support (and perhaps sometimes lead) adaptation to the requirements of climate change. This involves inverting the causal relationship, moving from assessing the impact of climate change on the financial system to exploring how changes in financial regulation can be an instrument in facilitating the needed adaptation of the real economy to the requirements of climate change.

In the article, Schydlowsky identifies how prudential regulation can be recruited to improve how societies deal with climate disasters. Storms, tornados, tsunamis, floods and other climate-originated disasters have recently increased in frequency and severity. Policymakers, including financial prudential regulators, need to improve the manner in which they deal with the climate crisis. This paper, therefore, joins the most recent interest in exploring how financial regulation can play a useful role in addressing climate change concerns.

The first section of the paper summarizes the salient effects of climate disasters on the real economy; the second section addresses the immediate consequences of the former on the financial system. The next section provides a typology of potential policy responses on the part of financial regulators, concentrating on existing tools that can be applied to new objectives. Thereafter, the potential for turning adversity into opportunity is addressed. The following section presents policies specifically pertinent to climate disasters. The concluding section explains why prepositioning policy responses is key and that the tools for regulators are already available.

Read the Journal Article