IMF to Deepen Coverage of Climate Risks in Financial Sector Assessment

The paper explains the difference between a macro-prudential stress test and a supervisory stress test. After a brief section on the evolution of stress tests at IMF, the paper presents the key steps of an IMF staff stress test. This is followed by a discussion on how IMF staff uses stress tests results for policy advice. IMF stress tests primarily apply to depository intermediaries, and in particular, global and domestic systemically important banks. In many cases, following the identification of specific sources of systemic risk, IMF staff have also included in the FSAPs stress tests of nonbanks, such as insurance and asset management companies and nonfinancial firms, as well as estimates of stress for households. IMF staff members also provide technical assistance in stress testing to a large number of its member countries.

IMF staff is increasingly using stress test results to support macro-prudential policy advice. Stress tests can support recommendations of micro-prudential measures, such as higher provisions or enhanced rules to related party transactions. Increasingly, recommendations of macro-prudential nature to mitigate systemic risk are also made. They include measures such as additional capital cushions, limits on credit demand (for example, debt-service-to-income ratios), and floors to capital ratios. Staff has also developed a general equilibrium model to signal when to loosen or tighten macro-prudential policy measures. The model uses macroeconomic and financial time series to derive risk measures and to assess fluctuations in default risk. It differentiates between idiosyncratic and aggregate risk. The dynamics of the model indicate that bank capital is undershooting during downturns and overshooting during booms. The model can be used to estimate nonfinancial firm and financial intermediary probabilities of default and quantify its deviation from the optimum. If risks are too high, macro-prudential policies should be tightened. On the contrary, if risks are too low, macro-prudential policies should be loosened.

Given the likely massive financial stability challenges due to climate change, IMF staff are prioritizing the assessment of the macro-financial transmission of climate risk. Work is ongoing to examine, on a pilot basis, financial stability risks associated with the transition to a low-carbon economy. The transition risks are multifaceted and inherently hard to model. Moreover, climate change and the adjustment to a low-carbon economy are subject to fundamental uncertainty. However, an essential element in the assessment of climate risk is the availability of sufficiently detailed information. Thus, IMF supports public- and private-sector efforts to adopt climate risk disclosures across markets and jurisdictions, particularly by following the recommendations of the Task Force on Climate related Financial Disclosures (2017). A well-defined, internationally comparable taxonomy of green assets, as well as disclosure standards, would help incentivize market participants to reflect climate risks in prices. Unfortunately, disclosures are still uneven across asset classes and jurisdictions. However, a comprehensive climate stress testing would require improved provision and accessibility of high-quality data.

Related Link: Policy Paper

Keywords: International, Banking, Insurance, Securities, Stress Testing, Systemic Risk, Macro-Prudential Policy, Climate Change Risks, Disclosures, Big Data, IMF