Financial System Resilience: The Climate Change Edition

Supervisors around the world wish to ensure that the financial system is resilient to climate change. To that end, current best practice is to formulate detailed long-run climate scenarios and then ask whether financial institutions, especially banks, can withstand the losses associated with them. These scenarios typically map the path of surface temperature, sea level, and the resulting economic damage over the next 30 or 40 or 50 years.

However, financial-system stress arises from sudden, widespread changes in the value and perceived quality of leveraged intermediaries’ assets, while climate change is likely to remain gradual over decades. As a result, skeptics reasonably doubt that climate change poses systemic financial risk sufficient to merit the use of scarce supervisory resources and a costly testing apparatus. To quote John Cochrane: “[B]anks did not fail in 2008 because they bet on radios not TV in the 1920s. Banks failed over mortgage investments they made in 2006.”

Fortunately, we now have low-cost, high frequency, forward-looking tools for monitoring climate-related sources of financial instability. In this post, we use one such tool to identify episodes in which the potential influence of climate change on systemic resilience may be worthy of attention. We also look at how an aggregate measure of financial system vulnerability evolves over time….

Central Banks' New Frontier: Interventions in Securities Markets

In his 2016 book The End of Alchemy, our friend and former Bank of England Governor Mervyn King provided a template for financial reform aimed at reducing the frequency and severity of crises. At the time, we were very cautious for two reasons. First, we believed that adoption of King’s framework would vastly increase the influence of central banks on private financial markets, something that could ultimately lead to a misallocation of resources in the economy and to a diminution of the independence of monetary policy that is necessary for securing price stability. Second, we doubted that most central banks had the technical capacity to implement the proposal.

Well, the landscape has changed significantly. During the pandemic, central banks intervened massively in private securities markets and there now appears to be no turning back. In a number of jurisdictions, monetary policymakers broadened the scale and scope of their lending and intervened directly in financial markets, going significantly beyond even their extraordinary actions during the 2007-09 financial crisis. As a result, we likely will be paying the costs that we feared could accompany the implementation of King’s proposal, so we might as well reap the benefits.

In this post, we discuss central banks’ pandemic interventions and the type of infrastructure needed to support them. We then review King’s proposal, highlighting how adopting his approach would make the financial system safer, while radically simplifying the role of regulators and supervisors ….

Cyber Instability

When terrorists attacked the World Trade Center on September 11, 2001, they also attacked the U.S. financial system. In addition to destroying critical financial infrastructure, the collapse of the twin towers closed the New York Stock Exchange and disrupted the payments system that links U.S. intermediaries, threatening to shut down banks, ATM machines and credit card operations across the country. Only extraordinary intervention by the Federal Reserve kept the system afloat (see, for example, Rosengren).

We have long argued that financial stability is a vital common resource (see here). As ECB Board member Cœuré suggests in the opening quote, the same applies to financial cybersecurity—the protection of financial information and communications technologies (ICT) and their associated networks from failures and attacks. The events of 9/11 and their aftermath dramatically highlighted the link between stability and cybersecurity. Moreover, because our financial system is so deeply reliant on ICT and on large, global networks, these two objectives are more closely linked than ever before: ensuring one means guarding the other.

In this post, we highlight the pervasiveness of cyberthreats as a source of operational risk in finance. Consistent with the Presidential Policy Directive 21 and a recent Presidential Executive Order aimed at strengthening cybersecurity, the U.S. government has designated financial services infrastructure as critical to national and economic security (see here). Nevertheless, numerous challenges—ranging from the availability of reliable data to the ever-changing nature of the attacks themselves—make the goal of safeguarding financial ICT networks very difficult. To be effective, cybersecurity efforts require mechanisms for preventing successful attacks, limiting their impact, and promoting quick, reliable recovery. Reducing vulnerability and contagion while boosting cyberresilience is a very tall order….

Commentary

Money, Banking, and Financial Markets