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.

CAROs: Climate Risk-Adjusted Refinancing Operations

Policymakers have argued that markets are not pricing climate risk appropriately yet, which may lead to a misallocation of resources and financial instability. Climate risk-adjusted refinancing operations (CAROs) conducted by the central bank are one possible instrument to address this issue. CAROs are characterized by interest rates on reserve loans, which depend on the climate risk exposure of the assets held by the borrowing bank. If private agents and the central bank have differing beliefs about the likelihood of the transition to a low-carbon economy, the allocation emerging without CAROs is, from the central bank’s perspective, suboptimal and may lead to financial instability. We find that an appropriate design of CAROs allows the central bank to influence bank lending in a way that induces the optimal allocation under its beliefs and eliminates financial instability. Moreover, we show that investment into climate risk mitigation reduces the need for central bank intervention and that CAROs can be used to achieve specific climate-related allocation targets

NGFS-GRASFI-INSPIRE exchange – CAROs: Climate Risk-Adjusted Refinancing Operations

Chiara Colesanti Senni (Council on Economic Policies) will present her research “CAROs: Climate Risk-Adjusted Refinancing Operations”, co-authored by Florian Böser (ETH Zurich).

The NGFS-GRASFI-INSPIRE exchange is designed to strengthen the connection, collaboration and research exchange between the central bankers, financial supervisors and the academic community to share and explore new and innovative research that advances the agenda on greening the financial system. New editions occur monthly and are co-organised by the NGFS Secretariat, INSPIRE and GRASFI (the NGFS’ two designated global research stakeholders). This is the 2nd in a five-part series focused on the impacts and limitations of green monetary policy.  This 11th edition is hosted by the GRASFI