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….

House Prices at Risk

Following the boom and bust of the 2000s, there is widespread agreement that residential real estate is a key source of vulnerability in advanced and emerging economies alike. Housing accounts for a significant fraction of wealth, especially for people in the middle of the income distribution, who are much less likely to own risky financial assets (see our earlier post). Furthermore, housing is highly leveraged, creating risks to both homeowners and their lenders.

In the United States, real housing prices have rebounded by nearly 40 percent from their 2012 trough. Today, they are only about 10 percent shy of their 2006 peak. As such, it is natural to ask whether we are once again facing a heightened risk of a crash. Enter “House Prices at Risk” (HaR)—a new worst-case metric created by the IMF to assess the likely scale of a housing price bust conditional on a bad state of the world. Consistent with the IMF’s previous work on “GDP at Risk” (see our earlier post), we view HaR as a valuable addition to the arsenal of risk indicators that allow market professionals and policymakers to monitor financial vulnerability….

Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

GDP at Risk

For several decades, central bankers have been the key risk managers for the economy and the financial system. However, they failed spectacularly to anticipate and prevent the financial crisis of 2007-2009. The financial regulatory reforms since the crisis—capital and liquidity requirements, resolution regimes, restructuring of derivatives markets, and an evolving approach to systemic risk assessment and (macroprudential) regulation—have all been directed at improving the resilience of the system to help sustain strong and stable economic growth. As a result, the likelihood of another crisis-induced plunge in GDP is much lower today than it was a decade ago.

But we still have plenty of work to do. We are at an early stage in the process of building a financial stability policy framework that corresponds to the inflation-targeting framework which forms the basis for monetary policy. Such a framework requires measurable financial stability objectives that are akin to a price index, tools comparable to an interest rate, and dynamic models that help us to understand the link between the two.

In this post, we describe a step forward in developing such a framework: the concept and measurement of GDP at risk....

Operational Risk and Financial Stability

Recent disasters—both natural and man-made—prompt us to reflect on the relationship between operational risk and financial stability. Severe weather in sensitive locations, such as Hurricane Irma in Florida, raises questions about the resilience of the financial infrastructure. The extraordinary breach at Equifax highlights the public goods aspect of data protection, with potential implications for the availability of household credit.

At this stage, it’s important to pose the right questions about these operational shocks and, over time, to draw the right lessons. We expect that systemic financial intermediaries’ risk managers, members of their boards, their regulators, and their ultimate legislative overseers are currently in the midst of an intensive review of exposures (and that of the financial system as a whole) to these risks.

So, what is operational risk (OR)? The Basel Committee for Banking Supervision (BCBS) defines OR as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”....

Central Banks and Systematic Risks

Modern economies are built by businesses that take risk. As Edison’s defense suggests, successful risk-takers need scope to experiment without distraction. Economies lacking institutions to support risk-taking are prone to stagnation.

By securing economic and financial stability, central banks play a key role in promoting the risk-taking that is fundamental to innovation and capital formation. On rare occasions, it is officials’ bold willingness to do “whatever it takes” that does the job. More often, it is a series of moderate, gradual actions. Yet, even then, the understanding that the central bank has the broad capacity to act—and, when necessary, to do so without limit—is a key factor underpinning the stability of the system...

Commentary

Money, Banking, and Financial Markets