Is India setting the new standard for Basel III supervision?
The Reserve Bank of India’s proportionate implementation of Basel III could serve as a blueprint for other advanced and emerging market supervisors seeking to develop regulatory guidelines that mobilise climate finance while mitigating the unintended risk-averse consequences of the Basel framework. Joseph Feyertag, Arunima Sharan and Agnieszka Smolenska explain.
Rising climate finance needs, limited fiscal space, and drastic cuts to international aid budgets have forced policymakers in both advanced and emerging economies to explore new ways of mobilising finance and investment for national priorities, including those related to national climate goals. The Reserve Bank of India’s (RBI) groundbreaking proposal to introduce regulatory adjustments that integrate climate risks into banks’ risk-weight calculations and lower capital requirements for infrastructure financing, in effect reducing the cost of financing climate projects, is a significant case in point.
The RBI’s proposal addresses long-standing concerns about the potential impact of the Basel framework, a set of global banking regulations that were introduced after the 2008 Global Financial Crisis. These regulations are widely considered a necessary safeguard against excessive risk exposure and are a pillar of global financial stability. However, certain aspects of the framework are considered unintentionally too risk-averse, particularly in the prudential treatment of emerging market exposures.
To date, little attention has been given to how emerging market supervisors may calibrate their Basel III implementation to support the goals of the low-carbon transition while at the same time safeguarding financial stability. The RBI has made a breakthrough on this front by proposing small but significant changes that increase capital requirements for climate-risk exposed assets, while reducing them for infrastructure finance. These changes essentially lower regulatory barriers to international finance flows towards India while encouraging the integration of climate risks into banks’ lending decisions and costs. The proposal thereby provides a blueprint for other central banks in both advanced and emerging economies seeking to integrate climate risks into the national implementation of the Basel reforms.
The unintended consequences of Basel III for emerging markets
The Basel framework — the most recent iteration of which is known as ‘Basel III’ — imposes capital requirements on banks to help them absorb losses, thereby reducing the likelihood of failures like the collapse of major financial institutions in 2008. In essence, Basel III requires banks to hold a minimum amount of capital to cover any unexpected losses from their assets, e.g. from government bonds or when providing loans to companies and individuals.
The amount of capital that banks need to hold is determined by the so-called risk weight of their assets: assets deemed ‘safe’ — such as AAA-rated sovereign bonds — are assigned a 0% risk weight. The weight becomes progressively higher for riskier asset types, surpassing 100% for certain exposures such as unrated or lower-rated corporate or SME loans.
However, the calculation of risk weights is not uniform across exposures between advanced and emerging economies. Research shows that, overall, risk weights for emerging economy securities are 1.43 times higher than those for advanced economy securities. Some of this differentiation is justifiable: many assets in emerging markets carry higher risk under the current framework — for instance due to their greater sensitivity to political instability or economic crises — leading to credit downgrades and application of correspondingly higher risk weights. Less justifiable reasons include the absence of external credit ratings for specific assets, which trigger the so-called ‘sovereign floor’ — a mechanism that automatically assigns a rating based on the sovereign credit rating. Emerging economies have also been vulnerable to unfair bias from external credit rating agencies.
Taken together, these differentiations risk disincentivising cross-border bank lending towards emerging markets and developing economies (EMDEs). However, the Basel Committee on Banking Supervision (BCBS) — which oversees the implementation of the Basel framework — explicitly grants supervisors flexibility in how they implement the framework to mitigate these effects. In a recent circular, the RBI exercised this flexibility and proposed tailored rules that could facilitate cross-border lending specifically for low-carbon and climate-resilient projects.
Integrating climate risks into the calculation of risk weights
The first and most significant of the RBI’s innovations — described by one bank executive as a “watershed moment for climate risk integration in banking” — introduces a provision allowing banks to conduct due diligence when applying risk weights to an exposure. As outlined above, risk weights are typically calculated on the basis of an exposure’s credit rating. The new provision, however, gives Indian banks explicit authority to adjust the weight upward based on their own assessment of risks:
“If the due diligence analysis carried out by the bank reflects higher risk characteristics than that implied by the external rating bucket of the exposure, [the] bank may assign a risk weight at least one bucket higher than the ‘base’ risk weight determined by the external rating.”
Crucially, the circular goes on to advise that:
“… banks may give proper consideration to climate-related financial risks as part of the counterparty due diligence.”
This is the first time climate risk has explicitly been incorporated into a central bank’s capital adequacy framework for credit risk. It effectively nudges banks to impose higher capital requirements — and therefore higher costs of capital — for lending to assets that are considered highly exposed to physical climate impacts or climate transition risks.
While the proposed regulations will not directly lower the cost of capital for climate finance, they increase the cost of lending to unsustainable or otherwise climate-exposed projects or entities. This, in turn, could free up capital for banks to finance activities with lower transition risk or ones that mitigate physical risk exposures, such as lending towards climate adaptation. Differentiation in the cost of capital ultimately creates an important market signal that incentivises borrowers facing a higher capital charge to reduce their transition risks to benefit from relatively lower costs of capital.
A second provision that would directly lower the cost of capital addresses a long-standing concern regarding the treatment of infrastructure assets, including climate-resilient and renewable energy or grid infrastructure. Infrastructure projects are typically financed through Special Purpose Vehicles (SPVs) — investment structures involving multiple parties that automatically attract higher risk weights of up to 130%. While the RBI maintains this risk weight for the pre-operational phase, it allows banks to reduce the risk weight to 80% for infrastructure assets that meet criteria for being ‘high quality’ and already in operation. This approach aligns with that of supervisors in advanced economies such as the European Banking Authority, which introduced supporting factors for infrastructure assets in 2019.
What can other central banks learn from the RBI’s approach?
The RBI has a track record of pioneering new approaches to integrating climate and sustainability considerations into its operations and policy frameworks. Its recent green deposit framework (2023) and the upcoming Climate Risk Information System (CRIS) (2026) are equally groundbreaking, as was the inclusion of small-scale renewable energy as a priority sector under its directed credit policy programme in 2015. These efforts reflect the RBI’s vision to build a financial system that can withstand climate shocks and support India’s low-carbon and climate-resilient transition — a vision that other central banks can take inspiration from.
The RBI’s proposal to lay out a clear measurement rule to integrate climate-related risks into capital requirements, while incentivising active analysis and due diligence of these risks by banks, continues this pioneering tradition. If implemented, the proposals will help discourage lending to pollution-intensive and transition-exposed sectors in India, while also reducing dependence on the credit ratings that determine risk weights under the Basel framework. Other central banks could similarly allow (limited) adjustment of risk weights based on assessment of their asset exposure to climate-related risks.
The regulations will not, however, address existing concerns about the high costs of capital for climate projects in emerging markets compared with advanced economies. High costs often originate from broader macro-financial and currency hierarchy-related factors. Where costs of capital are unjustifiably high — for instance where prudential treatment is not commensurate with the actual risks associated with an emerging market exposure — central banks could consider further tailoring of the Basel framework, which is widely seen as having contributed to stagnant infrastructure investment in emerging markets. One option would be to take the RBI proposal further by lowering risk weights for projects that are less exposed to the impacts of climate change and the low-carbon transition.
The RBI has essentially done this with respect to high-quality, operational infrastructure lending. Arguments for designating lower risk weights for a distinct infrastructure asset class under the Basel framework are supported by the relatively favourable risk profile of these projects: the average losses when a borrower defaults on an infrastructure loan in EMDEs are lower than they are in advanced economies, and only a quarter of that for corporate bonds more generally. Most risks for infrastructure debt occur in the initial phase of the projects in question. The RBI appears to reflect this risk differentiation between elevated short-term construction risks and lower long-term operational risks for infrastructure projects in its thinking and other central banks should consider doing the same.
The author would like to thank Rob Patalano for reviewing an earlier draft of this commentary.