Climate change: a challenge for financial stability?

In Short

Climate change is quickly rising in importance as a “new” risk factor to financial stability. A quick look at the Global Risk Report 2023 shows the predominance of climate. The basic translation mechanism to financial risk is rather straight- forward The financial sector mirrors the production,

Highlights:

  • Climate change is rising quickly in importance as a “new” risk factor to financial stability. It may negatively impact borrowers’ ability to service debt physically (via asset damages) and/or economically (via curbing production, sales, and profitability or via the devaluation of pledged collateral). 
  • Studies suggest that financial stability risks for the European financial system are currently manageable. However, about 30% of the euro area banking system’s credit exposures accrue from firms with high or increasing climate-related risk. 
  • Risks are unequally distributed across locations and sectors. This is true within Europe but even more on a global scale. EM countries are most vulnerable to environmental risk. They are facing the most severe impact and may lose a relevant part of their fiscal flexibility while mastering the green transition and containing climate-related risks.
  • Climate risks and costs are on a steep upward slope (chart). Thus, the true challenge for supervisors as well as financial intermediaries is to prepare for a future, still surrounded by huge uncertainties about the materialisation of the climate scenario. The ECB stress tests provide “state of the art” simulations based on three such scenarios. They suggest that financial losses would be lowest in an orderly transition to a low-carbon economy. By contrast, “doing nothing” would result in massive long-term GDP loss and financial damages. Climate change will not only impact firms, but also sovereign country risk via lower growth, higher inflation, and potential rating downgrades.
  • Regulation is currently overhauling the Basel framework and the EU macroprudential framework. Especially climate specific capital buffers will punish brown sector exposure so that investors will need to carefully scrutinise firms on their ability to decarbonize their activities. This will need to go hand in hand with more climate modelling expertise and a more in-depth analysis of individual (bank) exposures. Brown sectors and financial institutions with a relatively high brown exposure will likely underperform.
     

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Climate change: a challenge for financial stability?
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