Abstract:

We study bank capital requirements as a tool to address climate-related nan
cial risks and evaluate whether a prudential mandate for bank regulators remains
 appropriate in the presence of carbon externalities. We show that a prudential
 mandate maximizes welfare if carbon taxes are set optimally and fully characterize
 optimal capital requirements under such a mandate. Optimal transition-risk ad
justments can crowd out clean lending. When carbon pricing is insu cient, using
 capital requirements to address externalities can require sacri cing nancial stabil
ity or prove altogether ine ective. Capital requirements can play an indirect role
 by mitigating stranded asset risk, thereby making future carbon taxes credible.