Assessing Climate-Change Risk by Stress Testing for Financial Resilience

IMF Blog, February 5, 2020

Source details

Canonical URL: Assessing Climate-Change Risk by Stress Testing for Financial Resilience

Stress tests quantify how climate-related shocks could ripple through the financial system both globally and on a country-by-country level.
Stress tests capture amplification channels, including:
- linkages between financial institutions and the day-to-day functioning of the economy;
- interactions between solvency and liquidity problems;
- connections between governments and financial institutions; and
- interlinkages among financial institutions themselves.
Purpose: determine whether financial institutions (banks, insurance companies) would be able—even under the most adverse scenarios—to continue providing financial services when climate-related shocks occur.
Adding climate-related factors to existing stress-testing methodologies helps government and private-sector leaders prepare for a wide range of potential financial shocks triggered by climate dangers.

Historical progression:
- Initially: resilience of individual financial institutions.
- After the global financial crisis of 2007–09: emphasis on macroprudential stress tests to quantify risks to the financial system as a whole.
The IMF has extended macro-financial analysis and scenario exercises to cover a greater range of threats.
Climate risk integration:
- Physical risks (damage to property) and transition risks (policy and technology changes related to a low-carbon transition) are being incorporated into IMF stress tests.
- Newly refined stress tests assess the potential impact of such risks on financial stability and economic growth.

Use in practice:
- Natural disasters have been incorporated as shocks in IMF stress tests for small island states such as the Bahamas, Jamaica and Samoa.
- Example: a major hurricane can cause property losses and hurt tourism, triggering adverse scenarios.
Transmission:
- Direct losses occur through destruction or lower value of assets and collateral, affecting the value of financial institutions’ exposures to corporations and households.
Highlighted statistic:
- In some countries, total economic losses exceed 200 percent of GDP—as when Hurricane Maria struck Dominica in 2017.
Outlook:
- Future stress tests for physical risks will increasingly capture macrofinancial effects of more frequent and larger natural disasters.

Nature of transition shocks:
- Arise from changes in policies, technologies, and consumer and investor behavior as the global economy shifts away from industries reliant on non-renewable resources (example: the coal industry).
Financial-sector impacts:
- Financial institutions could incur losses on exposures to firms whose business models are not aligned with low-carbon economics.
- Potential manifestations: declining earnings, disrupted businesses, increased funding costs.
Risk amplification:
- Risks can materialize especially if the shift to a low-carbon economy is abrupt, poorly designed, or uncoordinated globally.
- Important next step: capture “second-round” effects—declines in asset prices leading to fire sales that further depress asset prices, creating a vicious cycle that amplifies the initial shock.

Benefits of climate-enhanced stress testing:
- Helps policymakers, corporate decision-makers, and investors anticipate climate-related threats.
- Delivers insights to central banks, supervisory agencies, think tanks, and academia to prepare for emergencies requiring speedy, agile responses.
Institutional role:
- The IMF and the World Bank can provide valuable scenario analysis and guidance through refined stress-testing frameworks.

Source: IMF blog page "Assessing Climate-Change Risk by Stress Testing for Financial Resilience" (February 5, 2020).