The Implications of Climate Change for Financial StabilityAnyone seriously interested in reducing climate change threats to global financial stability should take note of the Financial Stability Board’s research piece, ‘The Implications of Climate Change for Financial Stability.’ According to the FSB’s report released today, there are two significant types of climate change risks that could impact financial stability. “The value of financial assets/liabilities could be affected either by the actual or expected economic effects of a continuation in climate change (physical risks), or by an adjustment towards a low-carbon economy (transition risks).”
Data from the Bank for International Settlements, Banque de France and MunichRe show that economic losses from natural catastrophes have increased in recent decades. Increasing severity of hurricanes, fires, and other climate related events is likely to be very disruptive to the stock market. Volatility of those asset prices will challenge banks, insurance companies, pension funds, asset managers and other investors to improve their risk mitigation techniques. Moreover, it will be imperative for every level of government work in concert with private sector institutions to find solutions to the challenges posed by climate change.
Banks lending to companies and individuals in geographic areas sensitive to rising sea levels, hurricanes, and fires are likely to see rising credit risk. Climate change damage will make it harder and harder for individuals and companies to honor their loans and bond payments.
Economic losses resulting from weather-related catastrophes increased about 60% in just one decade. More frequent and severe extreme weather events will continue to make it harder for insurance companies to underwrite property and other types of insurance policies. Higher-than-expected claims will make it more difficult for insurance companies to remain well-capitalized to sustain unexpected losses and sufficiently liquid to avoid insolvency. If insurance companies were to be unable to meet their obligations or start charging higher premia, such actions could cause significant reverberations throughout the economy given insurance companies’ interconnectedness to banks, companies, and individuals.
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The Implications of Climate Change for Financial StabilityIt will be extremely important for financial regulators, ratings analysts, and investors to analyze banks, insurance, and other financial institutions extremely carefully. Analyzing financial institutions based solely on sectoral exposures or by portfolios is likely to hide concentrated exposures to a given counterparty, or borne by certain types of financial institutions. Banks’ risk managers, especially, will have to be on the lookout for liabilities that might arise when companies are held liable for losses related to environmental damage that may have been caused by their actions or omissions. The uncertainty surrounding what the extent of climate damage could be is what make managing this risk so challenging. Additionally, it is difficult to anticipate how financial institutions might react, such as banks reducing lending or insurance companies curtailing coverage could lead to damage to the real economy.
Importantly, the FSB report noted that financial institutions can take – and are taking – numerous actions to mitigate their climate change-related exposures. “However, the efficacy of such actions taken by financial firms may be hampered by a lack of data with which to assess clients’ exposures to climate-related risks, or the magnitude of climate-related effects. Robust risk management might be supported by initiatives to enhance information with which to assess climate-related risk.”
Recently, Federal Reserve watchers and pundits recently heralded that the Federal Reserve is set to take on climate change. While it may be the first time that the Federal Reserve mentioned climate change in its Financial Stability Report, it is important to note the Federal Reserve is not only a member of the international standard setter, the Financial Stability Board (FSB), but also Federal Reserve Governor Randal Quarles, is the Chair of the FSB. The FSB monitors and makes recommendations about all matters related to global financial stability, and in 2015 established the Task Force on Climate-related Financial Disclosures, chaired by former New York Mayor Michael Bloomberg; in July 2020 the FSB published a stocktake that considers global financial authorities’ experience in including climate-related risks in financial stability monitoring. Given the Federal Reserve’s leadership role at the FSB, we should expect that together with other financial regulators around the world, the Fed should create and enforce regulations for banks and other financial institutions, so that they establish transparent frameworks to identify how climate change could impact their credit, market, and operational risk exposures, as well as their levels of capital and liquidity.
Source: Forbes – Business