Crisk: Measuring the Climate Risk Exposure of the Financial System

The Federal Reserve Bank of New York has developed a novel and market-based measure of transition risks: Crisk.

Crisk captures the potential effect of transition risk on banks’ capitalisation and can be used to explore systemic risk and “severe yet plausible” scenarios. In a blog, financial research economist for the bank, Hyeyonn Jung, outlines the Crisk framework and explains why it is helpful to address current limitations in climate stress testing.

Transition risks can have adverse effects on banks’ capitalization and result in negative externalities on the real economy, such as a decrease in credit supply and economic growth. For example, changes in climate policies could create a shock that impairs borrowers’ ability to repay loans, resulting in reduced bank profits and greater chance of undercapitalisation.

Crisk is defined as the banks’ expected capital shortfall conditional on climate stress. The capital shortfall is taken as the capital reserves the firm needs to hold to meet prudential capital requirements. Crisk is a function of a given financial firm’s size, leverage, and the expected climate-related equity loss.

The framework can be applied to a diverse range of financial institutions and can be aggregated at the macroeconomic level to gauge system-wide risk. It can also admit a wide variety of climate scenarios, including “severe yet plausible” ones. This is done by taking the lowest 1% of the six-month return distribution of the climate risk factor to calibrate stress levels.

Jung applies this methodology to estimate the stock return sensitivity of large global banks to climate risk factors, or their “climate beta”, and finds it varies over time. In 2020, the aggregate Crisk value of the top four US banks increased by US$425bn, or 47% of their market capitalisation.

Jung outlines three key challenges to measuring climate risk and explains how CRISK addresses them.

First, past climate events do not reflect the changes in risk perception over time. To address this, the researchers construct a climate risk factor based on portfolios designed to decline in value as the transition risk rises and measure banks’ climate beta in response to this risk factor.

Second, market expectations may change without a direct experience of climate events, and asset prices can reflect climate risk changes in the distant future. The methodology responds to this by estimating the risk factor dynamically, allowing for time variation in the responses of firms and investors to changes in the transition risk.

Third, there is a lack of reliable data as voluntary climate-related disclosures “often suffer from incompleteness and inconsistencies in quality”. The Crisk framework confronts the data gap challenge by using only market data that is consistent in quality, comparable across firms, and “less susceptible to the noise and bias inherent” in voluntary climate disclosures.