The effects of climate change pose a potential systemic threat to the financial sector, says the Financial Stability Board (FSB) in a report that sets out its approach to developing a framework to assess and address these looming threats.
While climate-related shocks — including both physical risks, such as destructive floods and wildfires, and transition risks, such as policy shifts and technological innovations — can trigger typical stability risks, such as credit, market and liquidity risks, they may be more challenging to assess, given the novelty and uncertainty surrounding these kinds of events, the FSB said in the report released Thursday.
For instance, the report noted that “climate shocks are expected to grow in terms of their frequency and magnitude, which makes historical data ill-suited to assess future impacts.”
Additionally, climate-related events may also have non-linear effects if they represent tipping points, along with second-order and spillover effects between different parts of the financial system.
“There is also the possibility, given these complexities, that climate-related risks may be relatively more opaque and hence mispriced or mismanaged by entities in the financial system,” the report said.
“Under these conditions, climate risks could create correlated shocks whose impact can be magnified as they propagate through the financial system, in a similar manner to other unexpected shocks to the economy,” it added.
For example, fire sales in the asset management and insurance sectors, along with certain assets being deemed uninsurable, could lead to higher credit risk for the banks, the report said.
There could also be feedback loops created between the financial system and the real economy due to reductions in bank lending and reduced insurance coverage, the FSB noted.
And, in the event of a lack of insurance coverage, these risks could spread to governments, which end up serving as an insurer of last resort.
“Ultimately, the mutual amplifications could weaken the financial system, create systemic credit, market and liquidity risk and reduce economic activity, especially if exacerbated by the presence of other financial stability vulnerabilities at the outset of the climate-related shocks,” the report said.
In the face of this threat, the FSB has developed an analytical framework that aims to help regulators and policymakers assess the build-up of climate-related vulnerabilities in the global financial system. It also released a new set of forward-looking metrics designed to “help identify the drivers of climate risks and related exposures in the financial system and real economy, and to quantify their financial impact.”
The framework and accompanying metrics “will be refined as understanding of climate-related vulnerabilities evolves and as methodological and data issues are resolved,” the group said.
“The framework provides a forward-looking approach to be able to capture the unique aspects of climate risks while staying rooted in traditional financial stability analysis,” said Sarah Breeden, deputy governor for financial stability at the Bank of England (BoE) and chair of the FSB group that prepared the report.