Climate change represents a clear and present danger to the health and wellbeing of current and future generations. It is only natural that every unelected official who sets economic policy would reflect on what they can do to help tackle this crisis, within the remit that they have been given.

Authors: Professor David Aikman and Dr Richard Barwell, Head of Macro Research at BNP Paribas Asset Management

Published: 8 September 2022

Introduction: Climate change and the FPC’s remit

Climate change represents a clear and present danger to the health and wellbeing of current and future generations. It is only natural that every unelected official who sets economic policy would reflect on what they can do to help tackle this crisis, within the remit that they have been given.  The central bankers, regulators and supervisors who are collectively responsible for delivering financial stability around the world having been doing precisely that.  The Bank of England, which is responsible for both micro- and macroprudential regulation, is no exception.[1]

Our focus is on the macroprudential authority in the UK, the FPC, which has been given clear marching orders by the UK government – to assess the implications of climate change for the resilience of the financial system,[2] and subject to this, to support the government’s objectives regarding the transition to net zero.[3]  In this piece, we take a step back and ask:  what is the macro-prudential policy interest in climate change?  To answer this question, we think it makes sense to go back to basics and analyse the market failures and externalities that justify a role for macroprudential intervention in this area.  This assessment needs to explain both why the private sector, left to itself, is unlikely to manage this risk appropriately.  But also why micro-prudential supervision alone cannot address this challenge.

In our view, this train of thought potentially leads to a surprising destination. We think it likely that the incentives of micro-prudential regulators will lead them to have their foot on the accelerator, speeding up the financial system’s transition to net zero by, e.g., raising standards on climate disclosures, challenging regulated institutions on their capacity to measure, model and manage their climate-related exposures, and possibly even adjusting the regulatory capital regime. The FPC might find itself in the curious position of periodically putting its foot on the brake. The macroprudential authority might have to lean against both over-exuberant lending to green entrepreneurs and a mass exodus from carbon-intensive sectors, whilst also remaining vigilant on the risk of lax supervision on exposures that are seen to be in the public good.

Mendenhall Glacier, Juneau, United States by Matt Artz

Photo by Matt Artz from Unsplash

Revisiting the macroprudential rationale

If we want to debate from first principles how the FPC should respond to the climate crisis, then we need to first establish the economic rationale for macroprudential policy. At the risk of gross over-simplification, we offer below a highly stylised description.

For some free market idealists, there has long been a debate about whether any regulation of the financial sector is necessary.  However, economic theory and bitter experience has led most people to suppose that rational self-interest and market discipline cannot be relied upon to keep the system safe.

Financial institutions may unwittingly take excessive risk during booms as a result of disaster myopia. Market participants may become increasingly complacent after an extended period of economic stability.  Market discipline and rational self-interest can’t work if people don’t see the risks lurking over the horizon.

There may also be distortions that lead individuals and institutions to consciously pursue high risk strategies.[4]  A particular concern is the presence of spillovers or externalities.  The strategy pursued by an institution may influence the payoffs that other institutions in that market may expect to enjoy from the various choices available to them. In certain circumstances, my best response to your strategic choice is to pursue the same strategy myself. Where so-called “strategic complementarity” exists (Cooper and John (1988)), we should expect excessive risk being taken in booms – or as one former banker, Chuck Prince, put it “When the music stops, in terms of liquidity, things will be complicated, but as long as the music is playing, you’ve got to get up and dance.”

Similarly, the natural reaction of each institution in the bust is to take defensive actions to protect their balance sheet: sell financial assets; stop lending; hoard liquidity. The problem is that many institutions will face the same incentives at this point to do the same thing and the strategic complementarity may kick in again, creating a herd. If everyone is incentivized to take the same defensive actions at the same time, then what looks privately rational is collectively irrational. Fire sales of financial assets cause prices to collapse. Credit crunches leads to recessions. Liquidity hoarding creates funding stress everywhere.

Of course, not every defensive action has to be self-defeating. If credit was too cheap in the boom, then it is only prudent for a correction to be made. But there is a risk of an excessive tightening in credit supply with real economic consequences – with low income households and small companies likely to suffer disproportionately.

One might think that we would only need one policymaker to manage this problem: a supervisor to keep an eye on the banks and guard against excessive risk taking in the boom and to discourage excessive de-risking in a bust. That was indeed the received wisdom before the crisis. After the crisis, three concerns were raised. First, the risk that the supervisors may be captured by the institutions that they are supposed to monitor and therefore too likely to sign-off on their decisions. Second, the risk that supervisors may not “see the wood for the trees” – the consequences for the system and ultimately all balance sheets of excessive risk-taking in the boom and de-risking in the bust – given their narrow focus on the balance sheets of regulated institutions.  Third, that supervisors might not internalise the macroeconomic consequences of a sharp tightening in credit conditions.

The role of the macroprudential policymaker then is first and foremost to guard against these potential failures of both market forces (self-interest and market discipline) and microprudential supervision in boom and bust by taking a systemic perspective.[5]  This is done with a view to maintaining the provision of financial services. For example, the Bank of England defines financial stability as “the consistent supply of the vital services that the real economy demands from the financial system”. As we will soon discover, one needs a working definition of what constitutes a consistent supply and what defines a vital financial service to deliver that vision of financial stability.

Identifying the threat to resilience from climate change? Find the market and micro-pru failure

Perhaps the most striking thing about the direct threat to the resilience posed by climate change – whether that be the physical risks or the transition risks – is that the threat plays out over a very long horizon by the standards of conventional risks to financial stability.  The Bank of England’s own climate stress was elongated from five to thirty years “reflecting the longer-term nature of climate-related risks”.  It is also worth noting that the results of that stress did not suggest a first order threat to system resilience according to the Bank’s Deputy Governor for Prudential Regulation, Sam Woods:

By themselves, these are not the kinds of losses that would make me question the stability of the system, and they suggest that the financial sector has the capacity to support the economy through the transition.

It is reasonable to ask whether institutions should be able to manage such a slow-moving risk, by reducing their climate exposures.[6] The ease and speed with which financial institutions can shed these exposures will vary, but sooner or later contracts are up for renewal and loans mature.  At that point, banks and insurance companies can charge more for the same service or withdraw from the market.  It is of course possible that the financial sector will be too slow to react, but an assumption of static balance sheets (nothing changes for decades) seems pretty extreme.

One could argue that the financial sector – perhaps even wider society – is suffering from a form of ‘climate disaster myopia’. Climate change is a slow-moving risk and it may be that the really bad outcomes happen beyond the planning horizon of bank boards, so it is effectively ignored (Carney (2015)). It might also be hard for individual institutions or supervisors to gauge the true extent of the exposure. There are the inevitable gaps in data but of greater concern here are the gaps in our understanding: our capacity to model future changes in the climate and how they translate into potential losses on individual positions.  Policymakers can and are playing a role here. But one could argue that the responsibility for identifying the shortcomings in data and internal models and driving the industry towards best practice lies primarily with the microprudential authority.  The macroprudential authority would presumably only get involved if it became concerned that there was a system-wide failure to make satisfactory progress.

Alternatively, this may be another situation where the Prince dictum applies. Institutions may feel that they have to keep dancing and retain significant climate exposures, even though it is understood that things will be complicated and those exposures will pose a grave threat to their balance sheets once the music stops. At first glance, it is not obvious that there is a boom underway right now in the provision of financial services to companies on the wrong side of the transition to net zero but as always it pays for the authorities to remain vigilant. One key focus of the macroprudential research agenda on climate must therefore be to establish where and why such strategic complementarities might arise in this arena, leading institutions to herd on strategies which involve excessive exposure to climate risk.[7]

If you want to build a case for macro-prudential interventions to build resilience against the risks posed by climate change, it is not sufficient to demonstrate that self-interest and market discipline cannot be relied upon to manage those risks. You also need to make the argument that micro-prudential supervision may systematically fail to apply sufficient pressure on regulated institutions to correct the shortcomings of internal risk management. Based on what the current cohort of regulators are saying and doing, that does not seem particularly likely.  As Sam Woods observed: “Climate change is now firmly in the focus of prudential regulators across the globe”.

An obvious starting point for this exercise is once again considering the potential for strategic complementarity in defensive actions – that is, the circumstances in which one institution retreating from providing services to carbon-intensive sectors/firms would create incentives for its competitors to follow suit.  In particular, the FPC may therefore need to consider under what circumstances a mass exodus from climate exposures would be inconsistent with its definition of financial stability, ie the consistent supply of vital financial services.  This is the point where the micro- and macroprudential interests are more likely to diverge.


Once you frame the research agenda in this way – identifying where both the market and microprudential supervision fails – then the economics can lead the FPC in an unexpected direction. One might have assumed that the primary role of the FPC in the climate arena would be to nudge the financial sector and implicitly the micropru supervisors to do more, to go faster. It is not clear to us that the FPC will need to play that role. The policy stance will be dictated by the direction in which the market and micro-prudential regulation fail and that is not immediately obvious.

It is perfectly possible that financial institutions may choose to rapidly reduce their climate exposures in coming years because they feel unable to accurately calibrate the risks. As Kashyap (2022) notes: “private sector firms have a big risk management problem regarding climate risk in front of them”.  Some of those firms might decide it makes more commercial sense to cut the exposure than try to tackle that problem. One could even argue that the more work that policymakers do to bring these issues to the attention of decision-makers in the private sector, exposing the weaknesses of the current approach, the more likely it is that they choose to exit.

These institutions may also choose to retreat for reputational reasons, and it is not implausible that strategic complementarity might arise here too. Institutions may feel that the reputational cost of being associated with carbon-intensive business models rises as an increasing number of their competitors make public commitments to exit and “go green”. Even if that herding mechanism does not arise, it follows almost surely that the exit of some companies means a greater concentration of climate exposures on the balance sheets of those who remain. That in turn should bring greater scrutiny from microprudential supervisors and presumably even greater focus on solving that risk management problem.

There might also be risks that the FPC needs to consider on the other side of the transition.  The same reputational concerns and potential herding mechanisms that might lead banks to flee carbon-intensive exposures might lead them to flock towards green exposures. Of course, the social planner might view that as a good outcome, to help finance investment in a new, greener capital stock. However, not every budding green entrepreneur will blossom into a successful mature enterprise. Many of these projects will fail even along the most desirable transition path.

The FPC will no doubt be open to the possibility that risks may accumulate on bank balance sheets if there is a boom in “green finance”. That problem may be exacerbated if capital markets are willing to provide equity and debt finance on extremely generous terms to green companies, leading to elevated asset valuations. The key question that the FPC needs to grapple with is whether microprudential supervisors can manage these risks. The Committee might be concerned that supervisors would be more likely to downplay the risks posed by such green exposures, either because they believe those exposures are indirectly supporting activities that are in the public good or because they believe their superiors do not want to be seen to take any action that impedes the green transition.

The threat to the provision of core services from climate change

The chief concern from a macroprudential perspective is probably not that financial institutions will ignore climate risks and balance sheets in the financial sector will remain unchanged for the next thirty years as assumed in the stress test. The concern may arguably more that balance sheets start to adjust too rapidly as the financial sector starts to take defensive actions in response to climate risks and adds new direct and indirect exposures in green sectors. The question for the FPC is whether this would constitute a material breach in the provision of core services. Demonstrating that is not as straightforward as it sounds. Consider the following stylised cases.

  • those exposures where material losses are already highly likely given the physical risks or transitions risks that are already apparent from climate change. An example here would be the provision of insurance on properties which are already at extreme risk from, say, flooding or coastal erosion. It is not reasonable to expect the financial sector to continue to provide services in these circumstances – at least, not in the absence of fiscal support.
  • those exposures which are not of concern today but might well be several decades in the future as the physical and transition risks from climate build and given the uncertainty over how much the world will warm. Would the withdrawal of credit and insurance services to individuals and institutions in these circumstances be considered a breach of the financial stability objective? If so, the FPC would have to consider policies that would slow the pace of adjustment in the financial sector.
  • those exposures which will play a critical role in the transition. In part, the transition will involve new companies with green business models supplanting incumbents and investment in the new green capital stock will clearly require finance. But the transition will also involve many (if not necessarily all) of those incumbents, adapting their business models to the new reality. But that cannot happen overnight.  Companies with a big carbon footprint today will thus need ongoing support from the financial sector to make that change and in the limit to survive. Once again, the FPC might view evidence of an insufficient supply of core financial services to either group – the green entrants or the adapting incumbents – as a material breach of the provision of services.

This third concern seems to play on the minds of FPC members, based on the comments in recent speeches by Sam Woods and Anil Kashyap:

the financial sector cannot run ahead of the real economy: we need real change to make the economy more energy efficient and expand the provision of renewable energy. While that process takes place, banks and insurers need to provide finance to more carbon-intensive sectors of the economy, precisely in order to allow them to invest in the transition. Cutting off finance to these corporates too quickly could prove counterproductive, and have wide-ranging macroeconomic and societal consequences

the overall health of the economy and financial system requires an orderly rotation. In particular, there are immutable constraints on the speed at which green forms of energy production can be ramped up. There needs to be adequate credit made available to carbon-intensive firms so they can invest in greening during the transition period and so that the overall energy supply for the economy is adequate. If everyone cuts off the carbon-intensive producers indiscriminately and too quickly, that could be calamitous for the economy.

FPC to turn its hand to industrial policy?

A natural tool for the FPC to consider to address some of these problems is risk weights.  The policy action depends on the nature of the problem – that is, the nature of the collective failure of the private sector and microprudential supervision that the FPC wants to lean against:

  • If the FPC concludes that bank balance sheets are adjusting too slowly, and in particular that banks will continue to lend to carbon-intensive exposures for too long, then it could consider announcing some schedule of gradually rising risk weights over a multi decade horizon, which encourage banks to move faster. Given the horizon, such an action would presumably be motivated by the FPC’s secondary objective – supporting the government’s economic policy – rather than being warranted on resilience grounds.
  • By the same token, if in future the FPC concludes that there is a boom underway in green finance with banks lending on excessively generous terms to SMEs as they compete for business and reputational gains, and that microprudential supervisors are not inclined to tackle the problem, then the FPC might need to apply higher risk weights here too.
  • Finally, if the FPC concludes that the adjustment in bank balance sheets is taking place too fast such that companies who are gradually adjusting their business models and shrinking their carbon footprint lose access to key financial services, then the FPC might need to consider reducing (relative) risk weights for such exposures, presumably tied to some credible plan that the company concerned is making the necessary changes.

In passing, policy action in this area would look an awful lot like the FPC engaging in industrial policy over the next few decades to shepherd the transition to net zero. This might be precisely what the politicians who write the remit have in mind, but it is a different vision of macroprudential policy to the one that emerged out of the financial crisis. Presumably, one could also apply the same logic to justify the FPC engaging in industrial policy to improve the UK’s productivity performance, directing financing towards those companies that invest the most in R&D and innovation more broadly.


The role of macro-prudential policymakers in the climate transition is not clear.  Whether their job will be to encourage a faster transition to net zero or to slow down a disorderly exodus from lending to carbon-intensive companies will depend on which gaps emerge in both the risk management of financial firms and in the response of their micro-prudential counterparts.  On balance, we think it most likely that the micro-prudential authority will have its foot on the accelerator: helping to raise standards on climate disclosures; nudging regulated institutions to raise their game on measuring, modelling and managing climate risks; and adjusting regulatory capital requirements. That leaves the FPC with a perhaps uncomfortable role to play, in periodically applying its foot to the brake, tackling the risks that might arise in a boom in green finance or slowing the withdrawal of credit or insurance services to carbon-intensive sectors.

We have not solved these issues; they require detailed thought about the nature of the problem, the remit of the FPC and the tools available to it. But a sensible place to start would be to answer some basic questions:

  • what are the specific reasons that lead us to believe that private self-interest and market discipline cannot be relied upon to manage a risk that plays out over several decades? 
  • is climate disaster myopia a widespread problem? will regulatory efforts to tackle disclosures and other data shortfalls, and improve modelling capabilities mitigate that problem?
  • what are the relevant sources of strategic complementarity that might support herding around excessive or insufficient provision of services to carbon-intensive sectors or firms?
  • left to its own devices, would the private sector withdraw too fast or too slow from climate exposures?
  • why should we expect that microprudential supervision will fail to address this risk adequately? In particular, is it more likely that supervisors will be too soft on green or on carbon-intensive exposures?
  • how significant are the risks of a ‘boom’ in green finance, in the form of an imprudent relaxation in credit standards on green exposures?
  • if a relatively small number of companies with disproportionately large carbon footprints experience reduced access to financial services does that constitute a material breach in the FPC’s (presumably macro) assessment of the consistent provision of vital financial services?
  • what role should macroprudential policymakers play in driving a multi-decade industrial policy to achieve the optimal transition to net zero?  Should they play a similar role in tackling other social objectives, including weak productivity?

[1] See, for example, the publication of supervisory expectations and then the follow-up “Dear CEO letter” regarding the management of climate-related risks by regulated institutions; the implementation of the Climate Biennial Exploratory Scenario stress test; the participation in the Climate Financial Risk Forum alongside the FCA; helping to driving the agenda in the international arena in fora like the Central Banks and Supervisors Network for Greening the Financial System; implementation of global initiatives such as those on climate-related financial disclosures; and reviewing the Bank’s own holding of corporate bonds, to assess whether they could be adjusted to account for climate concerns.

[2] Under the Bank of England Act, the Government provides the FPC with a written remit each year, which provides updated guidance to the Committee on matters that it should regard as relevant to understanding the Bank’s Financial Stability Objective. The current guidance on climate, which dates from March 2021, informed the Committee that “the Committee should continue to regard risks from climate change as relevant to its primary objective. Climate change poses risks to the stability of the UK financial system, including physical risks, which arise from the increased frequency and severity of climate and weather-related events, and transition risks, resulting from a sudden or disorderly transition towards a net zero economy. In addition, the Committee should consider the potential relevance of other environmental risks to its primary objective.”

[3] “The government aims to align private sector financial flows with environmentally sustainable and resilient growth, and to strengthen the competitiveness of the UK financial sector by ensuring it can capture the opportunities arising from the greening of finance and to help foster the transition to net zero. To meet these aims, the government intends to introduce mandatory climate-related financial disclosure requirements and implement a ‘green taxonomy’, robustly classifying what we mean by ‘green’ to help firms and investors better understand the impact of their investments on the environment.”

[4] The externality might arise thanks to the way that principals evaluate the performance of the agents who act on their behalf, or the incentives that exist in remuneration packages that the principals provide to agents. Or the externalities might arise within markets, where the payoffs from a particular strategy directly depend on the strategy pursued by other institution.

[5] To be fair, although this wisdom of inserting that systemic perspective in regulation was only embraced after the crisis, the core arguments can all be found in the work of the pioneers many years before the crisis.  The standard reference here is Crockett (2000) but the key insights can be found in a speech given by Sir George Blunden, a Deputy Governor of the Bank, back in the 1980s:

“A bank may consider a course of action it wishes to take to be acceptable – as it may well be in a limited context. But the same course might, if widely copied by other banks, have unfortunate effects on the banking system as a whole. It is part of the supervisors’ job to take that wider, systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.”

[6] This definition covers any item on the balance sheets of financial institutions where there is a direct or indirect exposure to climate change, or the market and policy response to it. This definition encompasses insurance written on structures located in flood plains and loans to companies with high carbon footprints.

[7] For instance, an important recent paper by Degryse, Roukny and Tielens (2022) argues that banks may be reluctant to finance new green innovation because its widespread dissemination risks disrupting the value of legacy positions.

Further reading 

Blunden, G (1987), ‘Supervision and Central Banking’, Bank of England Quarterly Bulletin, August.

Carney, M (2015), ‘Breaking the tragedy of the horizon’, Speech, 19 September.

Cooper, R and John, A (1988), ‘Coordinating Coordination Failures in Keynesian Models’, Quarterly Journal of Economics, 103(3), pp. 441-463.

Crockett, A (2000), ‘Marrying the micro- and macro-prudential dimensions of financial stability’, Remarks.

Degryse, H, Roukny, T and Tielens, J (2022), ‘Asset overhang and technological change’, mimeo.

Kashyap, A (2022), ‘It’s the risk management, stupid!’, Speech, 11 July.

Woods, S (2022), ‘Climate capital’, Speech, 24 May.


  • David Aikman

    David Aikman joined King’s Business School in April 2020 as Professor of Finance and Director of the Qatar Centre for Global Banking and Finance. He spent 17 years working as an economist at the Bank of England – most recently in the Technical Head of Division role in the Financial Stability Strategy and Risk Directorate. He led the Bank’s work on various macroprudential issues.

    Aikman David
  • Richard Barwell

    Head of Macro Research at BNP Paribas Asset Management. Richard is responsible for promoting collaboration between investment teams and formulating alpha-generating investment views across all asset classes. Richard has worked at Royal Bank of Scotland (Markets & International Banking and Global Banking & Markets) and the Bank of England as a Senior Economist. Richard has 16 years of investment experience.

    Barwell Richard