Climate Risk and Central Bank Refinancing Operations

We analyse the impact of central bank refinancing operations on bank lending, investment in the real economy, and financial stability. In particular, we assess whether and how much climate risk-adjusted refinancing operations that apply differentiated interest rates based on the climate risk exposures of bank loans would improve financial market outcomes in terms of lower-carbon investment.

We base our analysis in the context of a financial market failure, where firms and banks underestimate climate risks. For that, we use a model where underestimating climate risks on the side of firms causes under-investment into climate risk mitigation (CRM), and underestimating climate risks on the side of banks induces excessive lending to firms exposed to climate risk. Misallocation of resources in the real economy and bank defaults induce a welfare loss in the economy. Banks’ lending decisions can be steered through climate risk-adjusted refinancing operations by the central bank, which, in turn, reduce the misallocation of resources in the real economy. This outcome is reinforced by a subsidy to companies for CRM. Specifically, the interest rate policy adopted by the central bank is such that banks’ cost of refinancing depends on the allocation of loans to more and less risky firms. This way the central bank can correct the belief-distorted lending decisions. The socially optimal allocation is achieved by a combination of subsidies and targeted refinancing operations, i.e., fiscal and monetary policy are complementary.