What is it about?
Regulators increasingly want bank capital requirements to reflect climate-related risks and encourage green lending. This paper shows why such policies may have less effect than intended. Under Basel III, the output floor limits how far banks using internal risk models can reduce their capital requirements below standardized levels. When this floor binds, lower capital requirements for green loans—or higher requirements for carbon-intensive loans—do not pass fully through to banks’ capital costs and lending rates. Even apparently substantial regulatory adjustments may therefore produce only small price differences between green and brown lending. The findings suggest that prudential regulation alone is unlikely to make green finance materially cheaper. Where the underlying risks remain high or uncertain, better data, guarantees, risk-sharing and measures that directly reduce risk may be more effective.
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Why is it important?
It shows why ESG research must be translated into credible capital models, or climate risk may be mispriced and better measurement may be penalised.
Perspectives
The real challenge is not whether banks should measure climate risk, but how to do so without rewarding poor measurement or penalising the banks that identify risk most accurately. Regulators must bridge ESG research and capital adequacy modelling while balancing credit risk, transition objectives and financial stability under considerable uncertainty.
Endre Jo Reite
Norwegian University of Science and Technology
Read the Original
This page is a summary of: Capital floors, model conservatism, and the limits of prudential incentives in green lending, Applied Economics Letters, July 2026, Taylor & Francis,
DOI: 10.1080/13504851.2026.2701288.
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