American exceptionalism on climate risk amplifies financial instability

Federal Reserve governor Chris Waller’s recent statements on climate change sound less like those of a bank regulator entrusted with preserving financial stability, and more like the remarks of a bank lobbyist intent on downplaying the risks at hand. Speaking at an event hosted by Banco de Espana on current challenges in economics and finance, Waller said:

“Climate change is real, but I do not believe it poses a serious risk to the safety and soundness of large banks or the financial stability of the United States.”

While Waller’s stance is shared by some conservative politicians, it deviates significantly from a growing consensus among global financial regulators – and those in the United States.

And Waller’s remarks come as the Fed remains under fire for inadequate supervision and regulation around the collapse of Silicon Valley Bank. Its failure unleashed a banking crisis around interest rate risk, a well-understood problem. Should we feel confident about Waller’s glib dismissal of climate risks to financial stability? Absolutely not.

Reports and statements from major financial institutions, including the US Treasury, the Financial Stability Oversight Council (FSOC), the Bank of England, and the European Central Bank and the European Systemic Risk Board, emphasise the clear and growing threat posed by climate change to major banks and financial stability. They all agree that climate risks may quickly propagate through the financial system and that central banks must act now to understand and mitigate the threat.

As Banque de France governor François Villeroy de Galhau recently stressed, monitoring climate-related risks is “not a ‘nice-to-have,’ but a ‘must-have’,” and is not an option for central banks.

Short-term horizons obscure long-term risks

So how did Waller reach such a different conclusion from his peers? Let’s examine some key assumptions he makes.

“Let’s start with physical risks,” he said. “Unfortunately, like every year, it is possible we will experience forest fires, hurricanes and other natural disasters in the coming months. These events, of course, are devastating to local communities. But they are not material enough to pose an outsized risk to the overall US economy.”

The phrase “like every year” implies the false assumption that the climate is not changing significantly or rapidly. To justify making that assumption, he suggests an absurdly short timeframe – “in the coming months” – as if central banks are meant to ignore systemic risks that will emerge over full years or decades.

Waller then cites a lone study that suggests certain types of banks have traditionally fared fine during the storms of the past, compensating for losses by underwriting new loans for recovery and repairs.

But it’s called climate change because the climate is changing, and much faster than scientists originally anticipated. We cannot merely use past data to predict future climate impacts. We must take a precautionary approach and heed the stern warnings from scientists about our dire current global trajectory. The US will not be spared the effects.

Even on a very short timeline, can we be sure that the physical risks won’t be material enough to pose an outsized risk to the US economy, as Waller suggests?

Insurance is the canary in the climate risk coal mine

Over the past two years, the consequences of climate change on financial firms have been tangible, with 11 insurers in Louisiana going bankrupt and even more forced to leave the state, while many others decline to write new policies. In Florida, 15 insurers have become insolvent since 2020, and at least 400,000 Floridians lost access to property insurance in 2022 alone. And in recent weeks, major insurance companies have announced they will no longer sell home insurance in California, citing the increasing risks of wildfires.

Insurance disruptions are the canary in the coal mine of climate financial risk, and climate shocks are making parts of America uninsurable. There is already evidence that changes to insurance affordability and availability are leading to credit rationing that disproportionately harms the lowest-credit consumers. Recent proposed guidance from the FSOC highlights that access to credit for low-income, minority, and underserved communities is a critical component of financial stability.

Major questions are being asked and will need to be answered in the coming years. How will insurers and consumers cope during the upcoming El Niño period, which carries with it a 66% chance that Earth will surpass the 1.5ºC warming level during one of the years between 2023 and 2027? How will banks respond to the growing insurance gap? How will more severe and frequent disasters impair the financial health of consumers and communities, and the banks that serve them?

Waller went on:

“What about transition risks? Transition risks are generally neither near-term nor likely to be material given their slow-moving nature and the ability of economic agents to price transition costs into contracts. There seems to be a consensus that orderly transitions will not pose a risk to financial stability.”

Except that there is no consensus of the sort Waller describes. Regulators worldwide generally regard transition risks to be material, relatively near-term, and significant enough to potentially cause rapid asset repricing, cascading defaults and financial instability. An orderly transition would certainly improve the outlook for financial stability but will not guarantee it, and we are currently not on track for this outcome anyway.

Climate change is a short, medium and long-term risk that requires new tools and thinking to analyse the trade-offs between physical and transition risk. Central banks should be leading the way in creating these new tools.

A laissez-faire attitude by US regulators – like the approach that led to the collapse of Silicon Valley Bank – will only increase the chances of significant financial instability. Preventing that outcome lies at the core of the Fed’s – and Waller’s – job.