How to assess environmental systemic risks? A New Macroeconomic and Financial Regulatory Framework

The regulatory framework that governs today’s International banking system only tackles the financial stability issue partially when considering that the main source of risks comes from the financial and banking system. In fact, we believe that Basel III regulatory framework is overlooking an important source of risk to the financial system and broader economy. Indeed, climate or environmental risks are systemic and threat the economic, social and financial system as a whole through two different channels: the direct risks associated with the increase of highly destructive climate disasters that can put a whole country into distress, and the indirect risks that emerge from the capacity or the incapacity of modern economies to shift into a low carbon system and stress the value of the assets that could cope with those changes fast enough. The Basel Committee should take climate risks mitigating objective in order to achieve its main goal regarding financial stability. This should prevent modern economies to fall into a new systemic crisis. However a sound macroeconomic and financial regulatory framework acknowledges all evolving systemic risks and their interrelationship. Risk insurance strategies can be complementary (when coping with climate risk can reduce the financial systemic risk) but not always fully substitutable. For example, a non-diversified capital reallocation to a carbon free single asset can create a green bubble that increases systemic financial risk. Authorities should be particularly careful with a specific sector that cumulates both climate and financial systemic risks, such as the real estate. Prudential regulatory framework should assess both risks without creating regulatory arbitrage that creates asymmetries and potential bubbles (brown or green) that lead to the increase of one or the other systemic risk