Green capital requirements: prudential regulation, credit allocation, and climate policy

We study bank capital requirements as a tool to address climate-related financial risks and carbon externalities. An increase in capital requirements for high-emitting f irms can reduce lending to clean firms. Such crowding-out can happen even under optimal prudential policy when high-emitting firms become riskier due to increased transition risk. Using capital requirements to reduce carbon externalities may re quire sacrificing financial stability or prove altogether ineffective. However, capital requirements can play an indirect role by making environmental policy credible. Our model can be applied in any setting in which a capital regulator considers both credit risk and credit allocation.