Climate risk and internal models don’t mix
The ECB wants banks’ internal credit models to incorporate climate risks. It's likely to get messy.
Credit risk can be a bank killer. Regulators are therefore obsessed with ensuring firms have enough capital to keep the lights on when loans go unpaid. The trouble is this preoccupation often means limiting banks’ freedom to evaluate risks using their own models and data. Climate risk concerns may add further constraints.
To understand why, it’s worth stepping back and digging into both parties’ incentives and motivations.