Thematic Tags: Macro financial risks and macroprudential supervision

Climate-related Financial Policy in a World of Radical Uncertainty: Toward a Precautionary Approach

Climate- and environment-related financial risks, both transition and physical, are characterised by radical uncertainty. This means conventional backward-looking probabilistic financial risk modelling is not fit for purpose in dealing with this uncertainty. While scenario analysis and stress testing to some extent recognise the uncertainty problem, they remain based on assumptions that are subject to significant uncertainty and do not sufficiently justify action in the short term, despite widespread recognition of the risks posed by inaction.

To address this lack of certainty, we have proposed the adoption of a new policy framework, the Precautionary Financial Policy (PFP) approach, to deal with the financial stability risks. This framework draws on two well established concepts: first, the ‘precautionary principle’ commonly adopted in environmental management policies to avoid passing certain thresholds, and second, modern macroprudential policy. PFP justifies fully integrating climate- and environment-related financial risks into financial policy, including both prudential and monetary policy frameworks. This helps to justify preventative actions now in order to mitigate the potentially catastrophic financial and economic damages created by climate change, and shape financial markets in a clear direction toward a preferred net-zero carbon future.

In terms of implementation, we propose the comprehensive integration of climate risk into capital adequacy requirements, monetary policy operations (including asset purchases and collateral criteria), quantitative credit controls and credit guidance, and the enhancement of financial system resilience. Policymakers adopting a precautionary approach should be aware of the likely short-term trade-off between efficiency and resilience, and likely resistance from market actors with shorter-term time horizons. There is a need to ‘learn by doing’ in this new environment.

Prudential instruments to scale up green finance: simulating the impact of green prudential regulations in an agent-based macro-financial model

The existing financial regulatory framework made notable progress in detecting, assessing, and containing systemic risks. However, a closer investigation of existing prudential instruments shows that several regulations under Basel III contain an intrinsic ‘carbon bias’ that creates barriers to aligning the financial sector with sustainable transition roadmaps. In particular, on the one hand, existing capital and liquidity regulations underestimate the risks related to so-called ‘green assets’ and potentially undermine the resilience of the financial system. On the other hand, they limit the bank capital available for green assets and favour dirty assets.

By considering the current state of the art, we highlight the lack of a comprehensive framework that is needed to analyse the impact of green prudential regulations. Thus, our research project aims to build such a framework and study how prudential regulations could deal with risks to financial stability arising from climate change. By building on theoretical research we have published in the past, this project aims to develop a tool to assess the implications of the implementation of different green prudential instruments under different macrofinancial scenarios. We will resort to the agent-based modelling approach (to build up a macrofinancial model) populated by a heterogeneous production sector, heterogeneous consumers, a banking sector, and a central bank.

This research will help in understanding, on the one hand, whether climate-related macroprudential tools lead either to market distortions or financial instability. On the other hand, it could assist in detecting which are the main factors that hinder or contribute to the effectiveness of such instruments.

Assessing forward-looking climate risks in investors’ portfolios: from theory to practice

Climate-related financial risk is characterised by endogeneity and deep uncertainty. The inadequacy of standard financial risk approaches to deal with these dimensions is a challenge for a smooth transition to a low-carbon economy. Across the last five years, we have developed a stream of work addressing this issue using a framework for climate financial risk management under uncertainty. This framework has been applied to the analysis of climate risk of financial portfolios, in collaboration with financial supervisors.

With this project, we aim to mainstream such a framework in microprudential and macroprudential policies implemented by financial supervisors and financial institutions belonging to the NGFS. We have engaged with relevant NGFS stakeholders through bilateral meetings, focus groups, and international conferences to co-develop narratives related to two main questions:

  • How can the available scientific knowledge on climate change mitigation be best applied to identify relevant scenarios of disorderly low-carbon transition?
  • What are the implications of scenario selection for investor decisions and for financial stability?

We found there is great importance to foster central banks’ and financial regulators’ understanding about:

  • Climate change mitigation scenarios (e.g., those co-developed and used by the NGFS), their limits and opportunities, and the conditions to use them to inform climate stress tests exercises;
  • The endogeneity of climate-related financial risks in climate stress test; and
  • The conditions for finance to be a driver or a barrier to the transition.

The stochastic impact of extreme weather events

In this project, we assess the impact of abnormal weather shocks on the global macroeconomy. Extreme weather events are random in size and location. We use stochastic trials to generate a distribution of weather shocks across the world and use NiGEM, a large macroeconometric model, to quantify the impact of these shocks on the macroeconomy. NiGEM links countries through trade and non-trade channels, and as such, a shock that impacts a single country or region will reverberate to other parts of the world. Our project captures the direct and the indirect impact of extreme climate events. Our analysis shows that extreme weather events cause economic volatility and that spillover effects magnify these events. We show that international spillover effects from trade and financial markets are important transmission channels, particularly for small open economies that are densely populated.

Our research has implications for at least two areas of central bank policy. The most proximate area of intervention is through the stress-testing framework where financial institutions should, in our view, disclose the risks posed by extreme weather events. Central banks can also adjust capital buffers to specifically account for assets that are exposed to such events and intervene in a more granular way using lending metrics such as the loan-to-value ratio. Second, where possible, the central banks can adjust the haircut imposed on the collateral that it accepts in its monetary policy refinancing operations by taking into account the financial risk posed by extreme weather events.

Low-carbon Transitions and Systemic Financial Risk

The transition to a low-carbon economy has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Most notably, Mark Carney’s ‘Tragedy of the Horizons’ speech warned of the potential of a transition-driven ‘Minsky moment’ whereby a disorderly process leads to a sudden collapse in asset prices.

We identify the channels through which a transition shock could lead to a systemic disruption. These include the downward repricing of carbon-intensive (or green) assets and a reduction in emissions-intensive production. We outline the approaches developed by existing studies to assess systemic risk, including the tracking of transition risk indicators such as bank exposure to emissions-intensive sectors, stress-testing frameworks, and network modelling approaches.

There is still much uncertainty on how to best measure the level of systemic risk posed by the transition, and therefore the size of this risk. Paradoxically, the realisation of systemic risks is more likely when the source of risk is not well understood. It is therefore important to consider the possible channels and work on their potential implications.

NGFS Scenarios Portal

Changes to our climate are unprecedented and so past data are a poor guide to the risks that may materialise in the future. The NGFS scenarios provide a framework to assess and manage the future financial and economic risks that changes to our climate might bring. They provide a coherent set of transition pathways, climate impact projections, and economic indicators at country-level, over a long time horizon and under varying assumptions. The NGFS scenarios provide a foundation for scenario analysis across many institutions, creating much-needed consistency and comparability of results.

1in1000

This new research program that aims to integrate future risks and challenges, notably those related to climate change, ecosystem service loss, and social resilience, into financial processes and regulations. The program will act as host to 2DII’s research and partnerships with financial institutions, central banks, NGOs, academia, and financial policymakers on three key areas:
– Developing performance standards and metrics to define what is a ‘long-term investor’ and a ‘long-term bank’;
– Designing risk management tools and frameworks to quantify climate change-related risks and related issues, notably ecosystem service and biodiversity loss, and threats to social cohesion & resilience;
– Building capacity, policies, and incentives to help financial institutions and supervisors mitigate and adapt to future risks and challenges.

Finance, climate-change and radical uncertainty: Towards a precautionary approach to financial policy

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy framework for dealing with them has largely focused on market-based solutions that seek to reduce perceived information gaps that prevent the accurate pricing of CRFR. These include disclosure, transparency, scenario analysis and stress testing. We argue this approach will be limited in impact because CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. In addition, this approach tends to bias financial policy towards concern around avoiding short-term market disruption at the expense of longer-term, potentially catastrophic and irreversible climate risks. Instead, an alternative ‘precautionary’ financial policy approach is proposed that offers an intellectual framework for legitimizing more ambitious financial policy interventions in the present to better deal with these long-term risks. This framework draws on two existing concepts — the ‘precautionary principle’ and modern macroprudential policy — and justifies the full integration of CRFR into financial policy, including prudential, macroprudential and monetary policy frameworks.

Financial Supervision beyond the Business Cycle. Towards a new paradigm

At the turn of the decade, a specific class of risks are coming increasingly into focus – long-term risks (LTRs). Pandemic, climate change, and social resilience represent major threats both to economies and sound and stable financial markets. This paper explores both the extent to which these types of risks are on the radar of financial supervisors and central banks, and mechanisms to drive financial supervision “beyond the business cycle”.

To this end, the paper reviews over 2,000 speeches, reports, and press releases as well as other public documentation such as Financial Stability Reports across eight major central banks (CBs) in the Global North & South. It presents an audit of the risk management activities of the eight central banks – categorized into measuring, monitoring and mitigation activities – and comes to the following conclusions:
Most quantitative measuring activities – in the form of stress testing – do not extend beyond the business cycle. The focus of those CBs that include LTRs is limited to climate change, and the regulatory use of climate stress tests remains unclear.
Monitoring of LTRs – tracked through Financial Stability Reports – is mostly backward and not forward-looking. The most monitored risks are those LTRs that recently materialized, such as Covid-19.
Mitigation policies, such as decarbonizing monetary policy, or setting green capital requirements rarely consider LTRs. Even though we argue that mitigation policies are the most important step of risk management, CBs – in particular CBs of the Global North – do not have mitigation policies in place that included LTRs.
The way forward:
Having identified long-term risk management gaps, the paper takes a step back and discusses a required shift in thinking needed to address these gaps.
As for the required shift, the paper calls for capacity-building – such as implementing precautionary measures and supporting effective policy coordination – in order to better prepare for long-term risks.