Stress Testing for Climate-Related Financial Systemic Risk

This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here

 

There is a growing consensus among financial regulators and central banks that climate change threatens financial stability. Climate change manifests in myriad types of financial risk (e.g., market, credit, liquidity, operational, and reputational risks), but it is the potential for climate-related financial systemic risk—the complex and nonlinear propagation of risk throughout the financial system with spillovers to the real economy—that is of critical importance to policymakers charged with maintaining financial stability. Coordinated macroprudential action is needed to ensure effective and efficient measurement and management of climate-related systemic risk, and in turn, an orderly transition to a more sustainable economy and resilient financial system.

Financial regulators and central banks are undertaking various initiatives focused on climate change and financial markets, including conducting research, convening stakeholders, surveying financial firms’ practices and disclosures, and issuing supervisory guidance. In particular, there has been a widespread interest among domestic and international policymakers in using stress testing to address climate-related financial risk, with financial regulators and central banks from England, Canada, France, Denmark, the Netherlands, Singapore, Norway, Australia, and the European Union beginning to incorporate climate change into scenario analyses and stress tests. The prevalence and varied nature of these climate stress test proposals and early practices give rise to questions about the relative effectiveness of different approaches and how the institutional design of financial stability regimes across jurisdictions enables or hinders progress. In response, my recent paper develops and applies evaluative criteria for stress testing vis-à-vis climate-related systemic risk measurement and management.

Risk Measurement

With respect to climate-related financial risk measurement, the paper proposes four evaluative criteria:

  • Scope: Supervisory stress tests are applied to all systemically important and materially climate-exposed financial firms, as determined by proxies such as size and portfolio carbon intensity, respectively.
  • Scenario Design: Scenario input variables reflect climate-related financial risks transmitted via physical and transition channels, with appropriate spatial and temporal resolutions and robust representation of uncertainty and interdependencies.
  • Metrics: Model output variables quantitatively and/or qualitatively measure how climate change affects the performance of tested firms and are translated into decision-relevant metrics.
  • Systems Analysis: Firm-level stress tests enable system-level analysis of the effects of climate change on financial stability, including the dynamic propagation of risks via counterparty contagion and concurrent exposures (within the financial system and across the financial sector and the real economy).

Risk Management

Noting that effective risk measurement is necessary but insufficient for mitigating the consequences of climate change for financial stability, the paper also proposes three risk management criteria:

  • Stakeholder Action: Stress testing and results disclosure encourage tested firms and their stakeholders to take actions that mitigate the effects of climate change on financial stability.
  • Mitigation Evaluation: Stress testing enables firms to evaluate system performance with and without various mitigations, resulting in more effective and efficient climate-related risk management strategies.
  • Evidence-Based Regulation: Stress testing provides evidence to regulators that informs the calibration of microprudential and macroprudential regulation to better manage the accumulation and propagation of climate-related systemic risk.

These criteria can be used to evaluate the effectiveness of climate stress testing proposals and early practices and to analyze the capacity of a given stress testing regime to incorporate climate-related financial risk. The paper describes the criteria in more detail and applies them to the Federal Reserve’s stress tests, arguing that the U.S. central bank could incorporate climate-related systemic risk into its existing stress testing regime and that doing so is consistent with its financial stability mandate. It also explores how stress testing can support financial firms’ work on climate risks (e.g., reducing climate-driven financial exposures), returns (e.g., prioritizing sustainable finance opportunities), and corporate responsibilities (e.g., fulfilling reporting commitments). Ongoing research applies these criteria cross-nationally, analyzing emergent best practices and opportunities for international regulatory cooperation in measuring and mitigating the effects of climate change on financial stability.

 

Dr. Mercy Berman DeMenno is a Nonresident Fellow with the Global Financial Markets Center at Duke Law School and Principal of Bosque Advisors, a boutique consulting practice specializing in risk, regulation, and resilience.

This post is adapted from her paper, “Environmental Sustainability and Financial Stability: Can Macroprudential Stress Testing Measure and Mitigate Systemic Risks Resulting from Climate Change?”

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