When it comes to the devastating impact of climate change, most people think of the harm inflicted on lives and livelihoods. Yet the effects of more frequent and extreme weather are just as consequential for the health of financial systems.
The physical impacts of climate-related shocks, such as hurricane damage to power grids, affect financial institutions and how they make decisions. So do the risks of transition to a low-carbon economy. Think of the costs of new carbon taxes or new laws that require phase-outs of fossil fuels before greener replacements are available.
To make well-informed decisions about future operations, banks, insurers, and others in the financial sector need tools to manage climate risks in their operations and balance sheets. At the same time, as financial supervisors monitor the resilience of the system, they need tools to adequately assess and supervise these risks.
Financial risk analysis
With the right tools, financial sector authorities can start to assess climate risks as a crucial input to gauging how to manage them with the right policies.
This is where the IMF comes in. The Fund’s Financial Sector Assessment Program already regularly examines the resilience of banks and other institutions, including with stress tests to better gauge systemic risks. These procedures are being retooled to incorporate climate risk analysis to better gauge financial stability risks from climate change.
Risk analysis typically entails development of scenario-based stress tests for assessing bank solvency. The process incorporates adverse macroeconomic scenarios specifically designed for the tests—including elements like economic contraction, rising unemployment, exchange-rate shocks, and falling asset prices.
These scenarios are then used as inputs when looking at relationships between these macro drivers and risk factors, such as credit risk and interest income, to estimate impacts on bank income and capital. Bank resilience is then assessed based on whether capital levels fall below regulatory thresholds.
Beyond the standard approach
Unlike conventional stress testing, climate risk analysis, at this stage, doesn’t focus on quantifying possible capital needs of financial institutions relative to the regulatory thresholds. Instead, the IMF approach focuses on measuring and raising awareness of risks. This reflects new challenges, including the complexities of modeling climate risk and its economic impacts over very long horizons and major data gaps.
