Green Capital Requirements

We study bank capital requirements as a tool to address financial risks and externalities caused by carbon emissions. Capital regulation can effectively address financial risks but doing so does not necessarily reduce emissions (e.g., higher capital requirements for carbon-intensive loans may crowd out clean lending). Reducing emissions via capital requirements may require sacrificing financial stability or may be altogether infeasible. Carbon taxes are not subject to these drawbacks. However, if the government cannot commit to future environmental policies, capital requirements can make higher carbon taxes credible by ensuring banks have sufficient capital to absorb losses from stranded asset risk.

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