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    FSB Report Examines Financial Stability Implications of Climate Change

    November 23, 2020

    FSB published a report that analyzes how climate-related risks might be transmitted across, and amplified by, the financial system, including across borders. The report highlights that financial institutions can take—and are taking—actions to reduce or manage their exposure to climate-related risks. However, some authorities find that these are not applied systematically by most firms. The efficacy of such actions taken by financial firms may also be hampered by a lack of data with which to assess clients' exposures to climate-related risks. Going forward, FSB plans to conduct further work to identify any data gaps by assessing the availability of data through which climate-related risks to financial stability could be monitored. This further work is expected to be completed by October 2021.

    The report builds on the FSB stocktake of experience of financial authorities in including physical and transition climate risks as part of their financial stability monitoring. The report explains that risks to financial stability from climate change can be divided into physical and transition risks. The current central estimates of the impact of physical risks on asset prices appear relatively contained but may be subject to considerable tail risk. The manifestation of physical risks—particularly that prompted by a self-reinforcing acceleration in climate change and its economic effects—could lead to a sharp fall in asset prices and increase in uncertainty. This could have a destabilizing effect on the financial system, including in the relatively short term. Market and credit risks could also be concentrated in certain sectors of the real economy and geographies. Disruption could also occur at the national level. Some emerging market and developing economies that are more vulnerable to climate-related risks, especially those in which mechanisms for sharing financial risk are less developed, may be particularly affected.

    Furthermore, a disorderly transition to a low-carbon economy could also have a destabilizing effect on the financial system. This could be brought about by an abrupt change in (actual or expected) public policy not anticipated by market participants, including that due to the increased materialization of physical risks as well as technological developments. In such a scenario, physical and transition risks might combine, amplifying their overall effect on financial stability. Climate-related risks may also affect how the global financial system responds to shocks. They may give rise to abrupt increases in risk premia across a wide range of assets. This could alter asset price (co-)movement across sectors and jurisdictions; amplify credit, liquidity, and counterparty risks; and challenge financial risk management in ways that are hard to predict. Such changes may weaken the effectiveness of some of the current approaches to risk diversification and management. This may in turn affect financial system resilience and lead to a self-reinforcing reduction in bank lending and insurance provision.

    The breadth and magnitude of climate-related risks might make these effects more pernicious than in the case of other economic risks. Moreover, the interaction of climate-related risks with other macroeconomic vulnerabilities could increase risks to financial stability. For instance, certain emerging market and developing economies that are particularly vulnerable to climate change are also dependent on cross-border bank lending. Financial authorities are beginning to assess how climate-related risks are managed by financial firms and to take actions to encourage firms to mitigate such risks. Three-quarters of financial authorities are considering climate risks in their financial stability monitoring and some are starting to quantify those risks. Scenario analysis is one tool that can be used by financial authorities to quantify the totality of exposures of financial institutions to climate-related risks within their jurisdiction. To date, such scenario analysis is being developed by the central banks in England, France, and EU. Some authorities have also voiced support for considering macro-prudential policies to mitigate the climate-related risks to financial stability. The report notes that robust risk management might be supported by initiatives to enhance information with which to assess climate-related risk.

     

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    Keywords: International, Banking, Insurance, Securities, Climate Change Risk, ESG, Data Gaps, Scenario Analysis, Macro-Prudential Policy, Micro-Prudential Policy, FSB

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