Supervising the Green Transition: How European Banking Supervisors are Responding to Transition-Related Financial Risks

Abstract

In this thesis I investigate how banking supervisors in the EU are adapting their prudential supervision to financial risks facing banks stemming from efforts towards decarbonizing the European economy. Keeping global temperatures well-below 2-degrees Celsius in accordance with the Paris Agreement implies that most global fossil fuel reserves must remain unburnable, putting banks at financial risk through their indirect exposure to these “stranded assets” (Allen & Coffin, 2022). While banking supervisors historically have based prudential action on assessments of risks identified through banks’ own internal risk management models, these “transition events” clearly escape such attempts at probability-based loss quantification, due to uncertainties associated with the time horizon over which they materialize and how such losses may interact with potential concurring macroeconomic shocks. Banking supervisors are hence faced with a conundrum: their traditional prudential approach leaves them with insufficient evidence of risk-taking that justifies prudential action in the present while being aware of the benefits associated with such early action, which far outweighs the costs of hastily implemented climate policies made in response to rampant climate change. In exploring this conundrum, I first simulate a market-based stress testing framework developed by Jung et al. (2021) to see what can be inferred about banks’ exposure to transition risks, using a tool relying on historical data. Based on an assessment of the framework’s limitations, I draw on content analysis to describe recent supervisory attempts at identifying, quantifying and responding to transition risks described in policy documents by EU banking supervisors. A broader characterization of these efforts is informed by van’t Klooster & Prodanis’ (2025) concepts of “deferential”, “guiding” and “alignment-based” supervision, which lets me assess the broader response towards transition risks by banking supervisors in the EU. I corroborate previous assessments within the political economy literature that EU-based banking supervisors have turned to view misalignment of banks’ portfolios with broader EU climate policy objectives as a source of transition risk. Contrary to previous assessments however, I find that they also still consider stress testing in scope, although in a modified form and serving different objectives. I argue that supervisors increasingly target policymakers in their communications, as targeting banks’ transition plans could have consequences for banks’ allocative practices more broadly. This leaves supervisors vulnerable to accusations of acting as policymakers, in the absence of concerted efforts to live up to their stated climate objectives by EU member states.