Should new prudential regulation discriminate green credit risk? A macrofinancial study for the output floor case

Abstract

This paper studies whether climate-related adjustments to the Basel III output floor can reconcile prudential discipline with environmental objectives. We develop an environmental general equilibrium framework with endogenous default risk and regulatory risk weights to compare a standard output floor with alternative climate-oriented designs. We show that while the standard output floor stabilizes banks’ capital adequacy and Risk-Weighted Assets (RWA) density over the cycle, it delivers no significant environmental benefits. Climate-oriented output floors deliver only limited environmental improvements and introduce a trade-off with prudential discipline when the green floor is deactivated, highlighting the difficulty of jointly achieving prudential and environmental objectives through capital regulation.