Environmental risks and bank capital measures: A theoretical approach

This paper examines the integration of environmental risks into pillar I capital requirements through brown-penalising and green-supporting factors. Using a principal-agent approach with a Walsh-type contract, the model formalises how political pressures can influence a supervisor’s decision to adjust capital buffers. The findings show that while these factors can redirect credit towards green projects, they do not guarantee a green equilibrium and may distort lending dynamics. Alternatively, bottom-up shifts in bank preferences or uncertainty in green returns can replicate these incentives without creating lending distortions by prudential policy. Ultimately, the paper suggests that alternative policy tools like subsidies or taxation may be better suited to address climate goals without compromising prudential assessments.