The Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation recently finalized guidance detailing how financial institutions should manage “climate-related financial risks.” This action, tracking with international efforts to incorporate climate-change considerations into prudential regulation and even monetary policy, is just the latest example of President Joe Biden’s “whole-of-government” approach to climate change.

The climate guidance will not only be a drag on economic growth—as newly empowered regulators leverage it to push financial institutions’ capital away from disfavored activities like fossil-fuel development and toward less productive uses—but will also fail to buttress financial stability. As Fed governor Michelle W. Bowman explained in her dissent, the guidance has “limited or no utility . . . in managing risk.” It is symptomatic of a broader inadequacy in the regulatory regime, which has produced a system more fragile than most realize.

Pollution and its consequences, including climate change, do exert some economic impact, as Fed governor Christopher J. Waller argued in a recent speech, but such effects are not significantly greater than the other risks that markets face. Despite alarmist declarations to the contrary, little evidence suggests that climate change poses a risk to the orderly functioning of financial markets. Physical risks—potential losses stemming from climate-change-related weather events and changes in the environment—have long been a core feature of underwriting associated with funding and insuring weather-sensitive assets. Where markets do appear to exhibit climate-change-related instability—as with the Florida home-insurance and California fire-insurance markets—the true cause is typically other policy interventions, such as laws favoring the tort bar, inflation driving up replacement costs (and therefore insurance rates), or negligence by state-regulated monopoly utilities.

Similarly, so-called transition risks—the potential effect of future climate-change regulation on financial assets—are highly speculative, relying on hypothetical changes in government policy. Should financial regulators push banks to address potential risks associated with changes in antitrust policy that may not be enacted? Entitlement reform is more likely to happen over a reasonable time frame (due to simple arithmetic) than decarbonization of the economy, yet surely it would be useless from a financial-stability perspective, and inappropriate from a political-economy perspective, for financial regulators to dictate that banks cut credit to seniors. Markets are well equipped to make judgments about what the future may bring. Financial regulators are not.

Regulators’ work on climate change reflects the intellectual failings of their approach to financial stability. The underlying assumption behind climate regulation and much of contemporary financial-stability efforts is that technocrats can somehow anticipate the risks associated with financial intermediation. This is farcical; the inherent advantage of a market is that it can better direct resources with respect to risks and opportunities than can central planners. A world of radical uncertainty allows for no financial seers.

This basic truth lays bare the folly of much of prudential regulation following the 2008 global financial crisis. Capital regulation today is governed by assumptions about various asset classes’ riskiness that will by definition prove to be incorrect, given an unknowable future. The legions of global technocrats formulating standards for risk-weighting assets miss this basic truth. When the stunning run on Silicon Valley Bank in March 2023 kicked off a broader contagion in the U.S. regional banking system, for example, it was a reminder that assumptions about a host of factors underpinning liquidity regulation can be wildly misplaced.

Increasing the prescriptiveness of prudential regulation actually tends to intensify financial instability. Systems with greater diversity in business models, including divergent approaches to managing risks on the asset and liability side of the balance sheet, are more likely to show resilience in a crisis. By pushing financial institutions to address the same risks in the same fashion, regulators are worsening systemic vulnerability. When an unanticipated shock comes, as it always will, banks that regulators pushed to conform to a certain set of standards will share the same vulnerability, potentially unleashing a cascade of failures. Furthermore, the complexity of complying with prescriptive financial regulation creates significant barriers to entry for new firms, increasing the concentration of the financial system in a few behemoths.

A wiser course would be to replace the great mass of post-financial crisis prudential regulation with streamlined rules that reflect the inherent uncertainty of markets. Risk weightings and other capital regulations could be replaced with a simple leverage ratio set at a higher level than today to reflect the reality that, while we cannot know from where future losses will come, we can be sure that they will come. Liquidity regulation, similarly, could be replaced with straightforward limits on maturity transformation—the mismatch between short-term funding and long-term investments that creates the inherent instability in banking. And rather than resorting to the ad hoc creation of crisis facilities like the Bank Term Funding Program that the Fed created in the wake of Silicon Valley Bank’s failure, a revamped discount window could provide a clear liquidity backstop to the banking system, letting the market manage the inevitable financial panics that are as old banking itself. Financial regulators can guard against financial instability to the greatest extent practicable only by acknowledging the limits of their prescience.

Photo: Douglas Rissing/iStock


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