Is the current macroprudential framework fit for climate systemic risk?

November 9, 2022|Written by
A partially collapsed wooden house, which is sagging in on itself and surrounded by broken timbers
Damage from a tornado in Kentucky, USA in December 2021. Climate risks are not yet being felt at a systemic level in financial markets © Ron Alvey / Greenpeace

Climate change and the transition to a low-carbon economy have a clear systemic dimension, and they potentially pose a systemic risk for the financial sector. This has been highlighted by several international and national financial authorities and urgently needs to be addressed.

Fortunately, systemic risks are not something new for central banks and supervisors, and a comprehensive toolbox of macroprudential policies and instruments has been developed to address them. The question is whether the current macroprudential framework can be deployed by central banks and supervisors to address climate systemic risk.

In short, the answer is yes. Climate systemic risk shares several features with other systemic risks and the macroprudential instruments currently available can, to some extent, be deployed to address risks arising from climate-related factors.

However, climate systemic risk also has its own specificities. Climate risks are complex and not yet observed on a systemic level in financial markets. How they build up and eventually unfold is uncertain, and largely dependent on the policies implemented now. Addressing climate systemic risk thus requires central banks and supervisors to review their current implementation practices and, if needed, adjust them.

Climate systemic risk is similar to – but distinct from – other systemic risks

The current macroprudential framework is a good basis to address climate systemic risk because the latter shares several features with other systemic risks for which the current framework has been developed. First, climate risks are widespread in the economy and the financial system. All financial institutions are exposed to them in one way or the other.

Second, climate risks materialise through the same risk categories as other financial risks, such as credit risk and market risk. Third, climate risks that materialise are likely to lead to substantial adjustments in asset allocation, which can potentially trigger sharp price corrections in financial markets. Finally, climate risks can be amplified by financial markets through spillover effects and interlinkages between financial institutions.

Climate systemic risk, however, also has features that are distinct from other systemic risks. For instance, climate risks are complex and not yet observed. Central banks and supervisors, as well as market participants, must rely on forward-looking data and prospective analysis to assess them. This is not a context in which these actors are used to navigating. Furthermore, the available data on climate risks are less precise and less complete than the data they are used to working with for other risks.

Another distinction is that climate risks are inevitable. They will materialise in one form or another, whether as transition shocks or physical shocks. This is different from other financial risks that have a probability of occurring but do not necessarily materialise. In addition, climate risks can materialise over a longer horizon than other risks, but they will very likely do so within the next decade.

Upgrading the macroprudential toolbox

The specific features of climate systemic risk require some adaptations in the use of the existing macroprudential tools. Central banks and supervisors will need to move beyond current practices when it comes to their implementation.

Central banks and supervisors need to adapt their policy decision and implementation processes. At present they base policy decisions and calibrate supervisory instruments using data that has been observed over financial cycles and that cover most of the financial institutions they supervise, as well as most of the firms these institutions engage with.

This is not possible for climate risks, which are yet to materialise on a scale that affects the financial system as a whole. In this context, central banks and supervisors need to move from backward-looking and relatively complete data to forward-looking data that are relatively scarcer and subject to a higher degree of uncertainty.

In these conditions, implementing prudential tools for climate systemic risk requires central banks and supervisors to be less averse to implementing prudential measures even if warning signals of systemic risk are not clear cut. In the context of climate risks, acting with caution might be less problematic than not mitigating a potentially very costly crisis.

The surface of a glacier seen from above, covered in fissures, with three channels of blue meltwater running horizontal
Meltwater on Greenland’s Petermann glacier. Banks and supervisors need to calculate climate risks with forward-looking, incomplete data © Nick Cobbing / Greenpeace

It might also call for implementing measures in some parts of the financial sector instead of looking for comprehensive coverage. For example, central banks and supervisors could start with instruments focused on the largest financial institutions. Climate risk data are much more available for such large financial institutions than for small ones, and the risk they pose to the financial system is also larger.

Central banks and supervisors could also first focus on economic activities that are most at risk from climate change and the transition. Firms within the thermal coal value chain are a case in point, as they are clearly much more at risk of being stranded soon.

Gathering the pieces for a comprehensive climate macroprudential policy

To start addressing climate systemic risk, central banks and supervisors should also consider using a sandboxing approach. They could begin to implement some possibly limited and focused measures, then improve and extend them based on the early experience they gather.

Two instruments stand out in the macroprudential toolbox available to central banks when it comes to addressing climate risks: systemic risk buffers (SyRB) and concentration limits. Central banks and supervisors already have experience in implementing such tools. SyRBs, for example, are already being used by several supervisory authorities in Europe. They are currently aimed at other systemic risks and could be deployed to address climate systemic risk as well.

These are two specific examples of tools that can be used by central banks and supervisors. More fundamentally, addressing climate systemic risk in the financial sector warrants a holistic approach, using all three pillars of the current macroprudential framework.

First, better disclosure by financial institutions and their counterparties is essential. As more and better data become available, central banks and supervisors can improve and extend their prudential measures. Market participants will also be better placed to manage climate risks adequately. Central banks and supervisors can play a key role in ensuring that disclosure frameworks provide the information needed by financial markets.

Second, financial institutions must put in place rigorous climate risk management practices, both throughout their operations and in their governance framework. Adequate management of climate risks at the firm level is central to ensuring a sound microprudential basis. However, this is currently far from being the case: the European Central Bank, for example, has repeatedly highlighted that financial institutions do not yet meet supervisory expectations when it comes to climate risk management.

Finally, an effective macroprudential framework should prevent the build-up of climate systemic risk over time. For this, policies that support an early and orderly transition must be implemented sooner rather than later since, as many supervisors have highlighted, such a transition is the scenario that most effectively lowers risks for the financial system.

Implementing a carbon pricing framework is of course first in line to support an early and orderly transition, but macroprudential tools such as SyRBs and concentration limits are part of the coherent and comprehensive climate policy package that is necessary to deliver incentives for an early and orderly transition, as well as addressing climate risks at the system level.

This page was last updated July 4, 2024

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