Thematic Tags: Macro financial risks and macroprudential supervision

Enhanced scenarios for climate stress-tests

Central banks and financial supervisors recommend that financial institutions run climate stress-tests, and several have developed their own. Climate scenarios are central to climate financial risk assessments. Moreover, conditional to additional factors, such as leverage, interconnectedness and climate policy credibility, financial institutions can absorb or amplify climate risks. Thus, climate stress-tests are a powerful tool to quantify the exposure of financial institutions to climate financial risks, to support investors’ climate risk management and central banks and financial supervisors on both micro and macroprudential measures.

Scenarios play a key role in stress-tests, including in climate stress-tests. The development of the scenarios of the Network for Greening the Financial System (NGFS) has been a pivotal development in the climate finance space. Going forward, we need to be aware that these scenarios are constructed without taking into account that the reaction of the financial system to the scenarios may impact, positively or negatively, on the realisation of this or that scenario. We refer to this circularity as the endogeneity of climate risks and it can cause a gap to emerge between the level of climate finance investments actually carried out and those assumed to be carried out in the scenario used in the climate stress-test.

Neglecting such endogeneity could lead to increased risks for financial stability. To address this challenge, central banks and financial supervisors can benefit from a recently developed methodological framework that connects processbased Integrated Assessment Models and the Climate Financial Risk model. This framework produces a new generation of climate mitigation scenarios that capture the key role of investors’ expectations, policy credibility and risk assessment within the realisation of the scenarios, yielding more robust climate financial risk analysis. This framework can be applied to the NGFS scenarios, and to different internal credit and financial risk models, to improve the relevance of climate stress-testing for decision making

Macroeconomic implications of climate change and transition risks for central banking in the Global South – the case of Nigeria

The research sheds light on a largely under-researched topic: What effects do physical and transition effects of climate change have for central banking transmitted through the balance-of-payments in the Global South? We conduct a country case study of Nigeria by triangulating primary qualitative data generated from ten semi-structured interviews with secondary quantitative data. The latter is used in a time series analysis, where we built two structured Vector Autoregressive models. We find that physical and transition risks both impact Nigeria‘s balance-of-payments through the financial and current account channel to the detriment of the central bank‘s objectives. Long-term physical effects of climate change and the strong oil dependence of Nigeria‘s domestic economy, its financial system and trade balance play a major role. Central banking in Nigeria is adversely affected when climate risks reduce foreign exchange income and increase the need thereof; when they put pressure on the exchange and inflation rate and undermine the acceptance of Nigerian financial assets. As a consequence, the central bank will have to keep interest rates notoriously high. These effects have recessionary implications for the domestic economy and impede economic diversification and a green transition in Nigeria.

Prudential transition plans: the great enabler for effective supervision and regulation of climate-related financial risks?

Prudential transition plans can be used in financial supervision and macroprudential monitoring to overcome some of the challenges inherent to assessing the climate-related financial risks that stem from the transition to a low-carbon economy. These challenges include the poor availability and consistency of data, modelling constraints, and the long time horizon over which risks may materialise. Prudential transition plans can provide supervisors with a multi-year account of financial institutions’ risk management strategies to mitigate transition risks and incorporate these risks within the supervisory time horizon, and result in a truer reflection of climate-related financial risks within the prudential framework.

If prudential transition plans are to be integrated into the prudential framework, it must be done in a manner that is proportional to the risks faced by financial institutions. This means accounting for the size of financial institutions and the threat they pose to financial stability, as well as their exposures to transition-sensitive sectors and overall transition risks.

The reporting of transition plans could be integrated into several tools within the supervisory and prudential toolbox, including the large exposures framework, stress testing, risk management under the Basel Framework Pillar II, and disclosure under Pillar III.

Climate-related systemic risks and macroprudential policy

Climate change has a clear systemic dimension: its consequences are not only widespread across all sectors and regions, but potential concentrations, spillovers and interlinkages within the financial system risk further amplifying its economic and financial impacts. The systemic nature of climate change for financial stability suggests the need for a macroprudential response that goes beyond a (microprudential) focus on individual firms and ensures a consistent approach across the financial system.

While climate change may be predictable, the timing of its financial impacts is uncertain. Therefore, central banks and financial supervisors must rapidly develop sound risk management practices adapted to a context in which policy decisions rely on imperfect data and high uncertainty.

Existing macroprudential policy toolkits can be deployed now to address climate-related systemic risks with some possible adaptations to reflect the unique features of climate-related risks, like the long time horizon over which they may materialise, their strong dependency on the speed and direction of the low-carbon transition, and the specific data and forward-looking measurement methodologies required to manage them.

Two possible instruments that can be tailored to address systemic climate-related financial risks are: (i) ‘systemic risk buffers’, to increase the resilience of the financial system to climate-related shocks and contribute to mitigating the build-up of future risks; and (ii) measures limiting exposure concentrations, which could target and thereby mitigate sources of risk where they are greatest. While there are undeniable challenges in devising these macroprudential responses to climate-related systemic risks (e.g. modelling complexity and uncertainty, partial data coverage), the risks will only increase with inaction. This points to the need for central banks and financial supervisors to adopt a forward-looking approach and progressive deployment of policy in their response to climate risk.

Inclusive green finance: A new agenda for central banks and financial supervisors

Climate change and environmental degradation can have profound economic impacts, which may translate into micro- and macro-financial risks that need to be addressed by central banks and financial supervisors. Green finance and financial inclusion have mostly been treated by central banks and financial supervisors as two distinct and largely unrelated agendas, despite meaningful overlaps between these two areas. Key target groups for financial inclusion tend to be disproportionately exposed to the impacts of climate change and environmental degradation, while also playing an important role in adapting to and mitigating environmental change.

Against this backdrop, central banks and financial supervisors can combine green finance and financial inclusion policies in an integrated inclusive green finance (IGF) approach. By accounting for equity concerns in the design of green policies, this policy approach can avoid any potential adverse effects on economically vulnerable groups, and enable central banks and financial supervisors to foster a just transition to an environmentally sustainable economy.

Central banks and financial supervisors have various tools at their disposal to translate the concept of IGF into actionable policies. By bringing together the complementary aims of green finance and financial inclusion, they can help to improve the livelihoods of low-income households and the business prospects of micro, small and medium-sized enterprises (MSMEs) while simultaneously contributing to climate change adaptation and mitigation, minimising associated risks for the financial sector.

The instruments that central banks and financial supervisors can use to leverage IGF for climate change adaptation and mitigation can be divided into market-shaping [indirect] policies and direct interventions. A range of IGF policies have already been adopted by the banks and supervisors, and there are emerging examples of best practice.

Climate, Lives, Inequalities, and Financial Frictions

Climate change is expected to have increasing impacts on our economies and societies. The extent of such economic impacts has generally been analyzed with integrated assessment models. These models have substantially improved over time to account for various features that may lead them to underestimate the extent of climate damages. There is, however, in our view, one crucial feature that so far has not yet been accounted for: financial frictions. We consider that financial frictions may amplify the impact of climate damages on the affected economies, to an extent that has not yet been measured. Hence, the main goal of this project is to extend integrated assessment models of climate change to include financial frictions, to measure the possibility that physical risks, the impact on financial assets that arise from climate- and weather-related events, may lead to financial crises, and what measures may be introduced to limit such possibility. Further, to better assess the impact of such financial crises, which add to the direct effect of the climate- and weather-related events that trigger them, the integrated assessment model is conceived to include income categories, an important aspect too often neglected in this literature and necessary to account for inequalities in how climate damages may affect people’s livelihoods. The integrated assessment model is also conceived to include a widely used regional decomposition. The project aims to provide clear policy lessons, analyzing the impact of a wide range of policy levers, including financial institutions, macroprudential policy, insurance schemes, and adaptation efforts, and their ability to mitigate physical risks.