Climate-related Systemic Risks and Macroprudential Policy

Existing macroprudential toolkits provide a “good starting point” for addressing climate-related systemic risk, say economists from the London School of Economics’ Grantham Institute. In this paper, authors Paul Hierbert and Pierre Monnin highlight systemic risk buffers and exposure limits as the two most promising avenues for building financial resilience to climate risk.

Climate-related financial risk is inevitable and “has a clear systemic dimension”. The authors say an orderly transition is the most effective way to contain these risks and, while risks may materialise in longer-medium term horizons, immediate-term actions are needed from the financial sector.

However, according to the authors progress by financial institutions is insufficient and is characterised by a lack of data and inadequate climate risk management. This manifests as misaligned portfolios and risk concentrated in certain financial institutions and regions.

The authors say a macroprudential approach to climate is essential due to the presence of interlinkages, cross border leakages, the risk of total system collapse, cascading and compounding effects, and the ongoing build up of systemic climate-related risk over time. Climate risks also affect traditional risk categories, including credit, market and liquidity risks.

Macroprudential policy builds financial resilience by addressing systemic risks, and tackles two key components: absorption of structural risk and risk build-up over time.

Challenges to adapting macroprudential tools stem from the unique aspects of climate risk, which is forward looking, uncertain, pathway dependent, nonlinear, and subject to various feedback loops. Sound management of climate risks rests on three pillars: data disclosure, risk management by financial institutions, and financial resilience to climate-related shocks.

The paper outlines the “two clearest options” within the existing toolkit and emphasises that measures should be targeted, proportionate, transparent. They should also be deployed progressively and in conjunction with wider policy reforms to avoid overburdening mandates.

Firstly, systemic risk buffers have features that make them applicable to climate risks. They are used to: address long term risks from the real economy, including external and sectoral shocks; manage concentration issues; and adjust lending incentives for systemically important financial institutions.

Secondly, exposure limits could be used to target and mitigate concentrated sources of risk. Exposure limits can target sectoral and regionally concentrated risks as well as those of single or connected counterparties. These can be adapted to target-specific, high-emitting activities, using either price-based or quantity-based measures. When a bank’s exposure exceeds a given level, supervisors can require they disclose the data needed to assess their capitalisation.

Modelling challenges, incomplete data and the risk of curbing transition efforts of high emitters each present implementation issues. However, the losses caused by whole system collapse far exceed those of miscalculating calibration and, the authors say, cannot justify inaction.