Macroprudential instruments that bank regulators might deploy to deal with climate-related risks to the financial system include capping “dirty exposures”, limiting debt service-to-income ratios for certain industries and higher countercyclical buffers for exposures to those industries. The Bank for International Settlements has released a policy brief prepared by its Financial Stability Institute that puts the case for climate-related macroprudential policy intervention and considers some of the instruments that might be used. The paper’s premise is that climate-related financial risks pose risks to financial stability that cannot be addressed by microprudential requirements alone.  It says authorities should be assessing whether they need to develop macroprudential policies specifically designed to address physical and transition risks that could result in systemic shocks with broader implications for financial stability. The paper says climate-related financial risks may affect the soundness of individual financial institutions in two ways. Banks may suffer from the economic costs and financial losses resulting from increasingly erratic climate conditions. And efforts to mitigate climate change by reducing greenhouse gas emissions may generate transition risks, as changing policy, technology and investor and consumer behaviour may erode the value of some of banks’ assets. Transition risks could also result in system-wide shocks, distressing financial markets and triggering asset price corrections. The paper says microprudential policy responses should aim to ensure banks have sufficient loss-absorbing capacity to manage such risks, the paper says. “In addition, the potential system-wide risks to financial stability posed by climate change suggest that authorities may also need to have at their disposal macroprudential instruments for addressing the systemic implications of climate-related financial risks,” it says. “In particular, the cumulative effect of lending to carbon-intensive activities will lead to negative externalities in the form of more emissions and hence higher aggregate risks to the economy and the financial system.” In a disorderly transition scenario, in which funding for carbon-intensive sectors suddenly becomes scarce and less affordable, businesses would find it difficult to clean up their operations and maintain stable business operations. “This would undermine their ability to repay and service their debt and reduce the value of pledged collateral. Such developments would probably give rise to significant credit losses and spillovers, with the potential to become systemic in nature.” The paper stresses that macroprudential instruments should not be designed to pursue broad climate policy objectives. A climate-related macroprudential framework should be informed by financial stability considerations alone. When it comes to macroprudential instruments, the paper says: “Borrower-based measures (for example, limits to debt service-to-income ratios) would dampen the accumulation of systemic risk. “When authorities raise the rate of the countercyclical capital buffer in response to a situation of increasing systemic risk resulting from excessive aggregate credit growth, the aim is to increase the resilience of the financial system.” The paper accepts that applying macroprudential instruments to climate-related financial risks involves trade-offs. Attempts to mitigate the systemic impact of physical and transition risks by containing outright exposures to carbon-intensive counterparties could well affect the availability and affordability of funding and, therefore, the prospect of an orderly transition path. “Such side-effects could be moderated if the scope of