## 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](https://www.imf.org/en/blogs/articles/2020/02/05/blog-assessing-climate-change-risk-by-stress-testing-for-financial-resilience)

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## Bibliographic details
- Authors: Tobias Adrian, James Morsink, Liliana Schumacher
- Published: February 5, 2020

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### Measuring the Risks
- 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.

### Ever Adapting: Evolution of Stress Testing
- 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.

### Physical Risks: Natural Disasters and Macrofinancial Effects
- 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.

### Transition Risks: Moving to a Low-Carbon Economy
- 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.

### Policy Relevance and Usefulness
- 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).*

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## References

- [عربي](https://www.imf.org/ar/News/Articles/2020/02/05/blog-assessing-climate-change-risk-by-stress-testing-for-financial-resilience)
- [日本語](http://www.imf.org/ja/News/Articles/2020/02/05/blog-assessing-climate-change-risk-by-stress-testing-for-financial-resilience)
- [Português,](https://www.imf.org/pt/News/Articles/2020/02/05/blog-assessing-climate-change-risk-by-stress-testing-for-financial-resilience)
- [paper](https://www.imf.org/en/Publications/Departmental-Papers-Policy-Papers/Issues/2020/01/31/Stress-Testing-at-the-IMF-48825)
- [Finance & Development](https://www.imf.org/external/pubs/ft/fandd/)
- [https://www.imf.org/external/pubs/ft/fandd/index.htm](https://www.imf.org/external/pubs/ft/fandd/index.htm)

_Source: https://www.imf.org/en/blogs/articles/2020/02/05/blog-assessing-climate-change-risk-by-stress-testing-for-financial-resilience_