Capital requirements play a central role in financial regulation and have significant implications for financial stability and credit allocation. However, in their existing form, they fail to capture environment-related financial risks and act as a barrier to the transition to an environmentally sustainable economy.

This paper considers how capital requirements can become green and explores how green differentiated capital requirements (GDCRs) can be incorporated into financial regulation frameworks.

Environmental issues can be incorporated into capital requirements using three different approaches: (i) microprudential approaches, which suggest that capital requirements need to be adjusted based on micro-level exposures to environmental risks; (ii) weak macroprudential approaches, which emphasise financial institutions’ exposure to systemic risks linked to specific sectors and geographical areas; and (iii) strong macroprudential approaches, whereby systemic risks are analysed through explicit consideration of macrofinancial feedback loops and double materiality. The use of microprudential and weak macroprudential tools can lead to an increase in physical risks at the system level – for example by undermining climate-vulnerable borrowers’ access to climate adaptation finance. According to strong macroprudential approaches, financial regulators should adjust capital requirements in a way that incentivises banks to support the ecological transition and economic resilience to climate change.

Green differentiated capital requirements (GDCRs), which can take the form of a green supporting factor (GSF) and a dirty penalising factor (DPF), are one of the tools that are consistent with the strong macroprudential approach. They can reduce physical risks, but they might have adverse transition effects if used in isolation. In the age of environmental crisis, strong macroprudential tools should play a prominent role in the greening of capital requirements. They need to be utilised in a way that is complementary with microprudential and weak macroprudential tools to minimise unintended adverse effects. If designed to accurately capture the environmental footprint of bank assets and minimise adverse financial side effects, GDCRs can contribute to the greening of the banking system and the reduction of systemic environmental risks. The positive effects of GDCRs can be enhanced if they are combined with other financial and non-financial environmental policy tools.