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.
Individual financial institutions as well as entire financial systems are affected by various interdependent risks. Aside from traditional types of risk, like credit, market, or operational risk, climate risks have gained momentum and consideration in the public, as well as with policymakers and regulators in recent years – in part because of movements like Fridays For Future. However, it remains to be seen whether climate risks are in fact quantifiable and differentiable from other types of risk.
From a financial perspective, risk is, by definition, the exposure to an eventuality leading to a financial loss. In this regard, climate risk describes the impact of climate change induced extreme weather events on financial institutions, leading to financial losses. For example, a hurricane intensified by severe climate fluctuations destroys the harvest of farmers. As a consequence, the farmers suffer losses and may default on their creditors. An individual default has only a limited effect on the bank providing the loan, but defaults on large, or concentrated exposures, can result in the bank’s financial distress. Regional banks, which tend to concentrate on specific sectors, are particularly prone to this kind of risk. Their defaults can cause regional financial instability.
Climate risks have always influenced both macroeconomic and financial stability to a varying degree. Although the number of climate change-related events increased by almost a factor of six during the past five decades, the interest of the public, policymakers, and regulators has piqued just recently. As a first important step, United Nations member states adopted the goals of the United Nations Sustainable Development Agenda 2030, addressing the protection of the planet and the end of poverty. Furthermore, 188 states and the EU, who combined emit almost 97% of global greenhouse gas, have signed and ratified the Paris Agreement within the United Nations Framework Convention on Climate Change to collectively combat climate change.
Climate change can affect financial systems in manifold ways that are not only physical, but also non-physical. Physical risks result from the direct effects of climate change, including both long-term changes in climate patterns and disruptive catastrophic events such as droughts, floods, and storms. In the context of financial institutions, physical risks essentially comprise three sub-risks: business risks, credit and counterparty risks, and underwriting risks. In contrast, non-physical risks occur when climate change has an indirect impact on financial systems. Again, non-physical risks can be broken down into multiple sub-risks, namely policy and legal risks, technology risks, market and economic risks, and reputation risks. Irrespective of their origin, non-physical risks can manifest in either liability risks – owing compensation from damages or losses from climate change – or transition risk, resulting from efforts and reforms towards a low-carbon economy. Figure 1 illustrates the breakdown of climate risks on financial institutions.
Figure 1 – Climate risks on financial institutions
While this overall classification provides a distinction between different types of climate risks, it is vital to highlight their inseparability. The risks are interdependent and even mutually reinforcing, creating an extremely complex picture and contributing to the challenge of measuring their impact on financial stability.
The relevance of measuring financial stability
Since the last great financial crisis in 2008, financial stability and systemic risk have come to play a pivotal role in financial regulation. The crisis exposed the vulnerability of the financial system and proved that even solid financial institutions unaffected by specifically risky exposures can be severely compromised through contagion channels.
The risk of being affected by a systemic crisis is defined as systemic risk. This type of risk has gained momentum since the crisis and led to the development of macroprudential policies, complementing microprudential financial supervision. Both scholars and macroprudential regulators have developed several measures of systemic risk, aiming to quantify the risk of financial distress. The measurement of systemic risk, however, is in no way universal. Instead, systemic risk can be operationalised along many different dimensions. In particular, we distinguish micro-level measures and macro-level measures. Notable micro-level measures to assessing systemic risk on the level of a financial institution are CoVaR (Adrian & Brunnermeier, 2016), MES (Acharya et al., 2017), and SRISK (Brownlees & Engle, 2017). Macro-level measures such as CATFIN (Allen et al., 2012) capture the system-wide risk. All measures have strengths and weaknesses, depending on the dimension of systemic risk that is captured.
Measuring the impact of climate risks on financial stability
Climate risks have the potential to lead to systemic financial distress. This can certainly be the case on a regionally contained level due to large or concentrated exposures in that region. Yet contagion effects can cause spill-over and global systemic instability. Therefore, it is vital for financial regulation to measure, assess, and supervise the potential effects of climate risk on a qualitative and quantitative level. The quantitative measurement, however, is highly problematic for at least two reasons.
First, the definition and differentiation of climate risk is a difficult undertaking. As shown above, climate risks are not easy to grasp and have many different shapes and dimensions. Furthermore, the meaning of related terms such as climate change and sustainability are not globally harmonised. Thus, climate risks can hardly be differentiated from established types of risk, such as geographical risk and credit risk. Adding to the complexity, it is difficult to attribute the actual impact of climate change to occurring weather events. As a result, climate risks are almost impossible to quantify in a consistent approach.
Second, the measurement of systemic risk is highly problematic. Regarding the multitude of different measures, all existing risk measures capture only certain facets of systemic risk, depending on the specific definition. The result can be a biased perception of the effects of climate risk, entirely depending on the operationalisation of the measure. At the same time, the validity of the measures is controversial and is often determined by the specific crisis it is designed to explain. Kund (2018) tests the predictive power of different systemic risk measures and shows that the micro-level measures CoVaR, MES, and SRISK qualify only to a limited extent. Therefore, it is not clear whether the risk measures really capture the risk of systemic instability. For these reasons, systemic risk is, and remains, an extremely obscure concept.
Urgent need for empirical evidence
Measuring the implications of climate risk on systemic risk and systemic instability is highly problematic. This is due to the ambiguous nature of the term “climate risk” on the one hand, and the lack of validity of systemic risk measures on the other. However, the quantitative assessment of climate risk is a pressing topic because of the severe consequences climate-related events can have on the financial sector and the entire economy.
Such an assessment is even more important because banks are supposed to play a key role in the economic transformation process. According to the Action Plan of the EU Commission on Financing Sustainable Growth, banks are essential for the transformation into a resource-efficient circular economy. They are predestined to finance the intended ecological transformation of the economy, particularly in bank-based economies.
The scientific assessment of climate risk implications for the financial system and systemic risk is still underdeveloped, which might just be the result of the many obstacles quantifying the effects. Given the vital role the financial system plays in the economy, these issues deserve much more attention in scientific research. In particular, there is a need for empirical research evaluating the effects on systemic risk and providing guidance to regulators in order to prevent future systemic crises.
Kristin Julie Kellner is a research assistant at the Chair of Management and Social Media at the Johannes Gutenberg-University Mainz, Germany.
Matthias Petras is a management consultant for financial institutions at zeb rolfes schierenbeck associates gmbh and researcher in the Department of Bank Management at the University of Cologne, Germany.