Prudential instruments to scale up green finance: simulating the impact of green prudential regulations in an agent-based macro-financial model

The existing financial regulatory framework made notable progress in detecting, assessing, and containing systemic risks. However, a closer investigation of existing prudential instruments shows that several regulations under Basel III contain an intrinsic ‘carbon bias’ that creates barriers to aligning the financial sector with sustainable transition roadmaps. In particular, on the one hand, existing capital and liquidity regulations underestimate the risks related to so-called ‘green assets’ and potentially undermine the resilience of the financial system. On the other hand, they limit the bank capital available for green assets and favour dirty assets.
By considering the current state of the art, we highlight the lack of a comprehensive framework that is needed to analyse the impact of green prudential regulations. Thus, our research project aims to build such a framework and study how prudential regulations could deal with risks to financial stability arising from climate change. By building on theoretical research we have published in the past, this project aims to develop a tool to assess the implications of the implementation of different green prudential instruments under different macrofinancial scenarios. We will resort to the agent-based modelling approach (to build up a macrofinancial model) populated by a heterogeneous production sector, heterogeneous consumers, a banking sector, and a central bank.
This research will help in understanding, on the one hand, whether climate-related macroprudential tools lead either to market distortions or financial instability. On the other hand, it could assist in detecting which are the main factors that hinder or contribute to the effectiveness of such instruments.