The financial consequences of climate change and the necessary transition to global Net Zero by 2050 have made it difficult for financial institutions to change the way they make decisions quickly enough. A working paper published by researchers at the European Central Bank provides evidence for how the financial sector could be insulated from any losses by creating a systemic risk for the entire sector.

Until now, most of the regulatory responses to the risks associated with climate change have been incentives for non-financial companies to make green investments, greater disclosure by corporations and financial institutions about their financed emissions, and climate stress-testing exercises by central banks and supervisors.

The Systemic Risk Buffer was developed to reflect the overall level of near-term transition risk exposure of the financial institution – within the coming three years — and not be linked to individual green or dirty assets. Instead of adjusting the risk weighting of individual exposures, as a green supporting factor or dirty penalizing factor would do, it groups financial institutions into buckets based on the potential transition risk relative to their risk-weighted assets.

Using the collected data for calibrating a systemic risk buffer provides a tangible use for the stress tests and a data-guided way to balance the risk of financing climate-exposed sectors with the short-term gain that banks have by continuing to provide financing. Transition risk buckets offers substantial leeway for banks to finance companies transitioning activities from unsustainable to sustainable activities without facing increases in their capital requirement.