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….

U.S. Gets a Start on Climate-related Financial Risk

Co-authored with Richard Berner, NYU Stern Clinical Professor of Finance and Co-Director, Volatility and Risk Institute.

Many sources of risk threaten the U.S. financial system. Pandemic risk and cyber risk are at or near the top of our list of nightmares. Yet, with the UN Climate Change conference (COP26) under way in Glasgow, attention is shifting to efforts aimed at limiting the economic and financial damage from climate change, including a timely new “Report on Climate-relat ed Financial Risk” from the U.S. Financial Stability Oversight Council (FSOC).

As the Report makes clear, U.S. policymakers need a far better understanding of climate-related financial risk. Indeed, when President Biden issued an exec utiv e order in May instructing financial regulators to conduct a thorough risk assessment, the United States already was behind other advanced economies. As an initial response to the President’s directive, the Report catalogs the range of climate risk threats, describes actions individual U.S. regulators have begun taking to address them, and lists many things that still need to be done. By setting priorities, the FSOC is now putting climate change “squarely at the forefront of the agenda of its member agencies.”

In this post, we highlight three themes in the Report: (1) the ongoing rise of physical climate risk; (2) the conceptual challenges associated with measurement, as well as the data gaps; and (3) the benefits of scenario analysis as a tool for assessing the financial stability risks arising from climate change. The key lesson that we draw from scenario analysis is that a financial system resilient to a range of other shocks is more likely to be resilient against climate risk. Put differently, a less-resilient financial system is vulnerable to all types of shocks, including those arising from climate change.

Central Banks and Climate Policy

Avoiding a climate catastrophe requires an urgent global effort on the part of households, firms and governments to reduce our reliance on fossil fuels. Like many economists, we support a carbon tax. We also favor generous fiscal support for R&D to substitute for fossil fuels and remove carbon from the atmosphere.

What role should central banks play in this global effort? That is the prime focus of this post. We argue that central banks must preserve the independence needed for effective monetary policy. That implies only a modest role in addressing climate change.

Central banks are involved in both financial regulation and monetary policy. In each case, there are some things that central bankers can and should do to help counter the threat posed by climate change. As financial regulators, they should implement an improved disclosure regime and develop tools to ensure the financial system is resilient to climate risks.

In conducting monetary policy, central bankers should follow a simple, powerful principle: do not influence relative prices. To be sure, it is and should be standard practice to use interest rates to influence relative prices between consumption today and tomorrow. However, central banks ought not influence relative prices among contemporaneous activities. We will see that achieving this form of relative price neutrality may require central bankers to shift the composition of their assets and to alter the treatment of collateral in their lending operations….

Commentary

Money, Banking, and Financial Markets