Projects: CFR2-JT

Supervision beyond the business cycle: A framework for long-term financial supervision

Financial supervisory mandates are interpreted to ensure financial stability ‘over the business cycle’ (three to five years). New risks are challenging this paradigm, as they manifest themselves both over longer time horizons and as secular, one-directional shocks. We have designed this exploratory conceptual project to identify potential mechanisms and levers financial supervisors can mobilise in order to ‘supervise the long-term’ and reframe their mandate to cover more long-term risks.

Current financial policy and supervisory analysis falls into two categories. In the first category, financial policy analysis seeks to identify potential levers within the mandate to supervise risks over the business cycle (e.g., capital requirements) or support societal goals. The second category involves the development of tools to analyse the financial materiality of long-term risks (e.g., climate scenario analysis). Missing within this paradigm is the ‘adapter’ that allows for the integration of the second category of analysis into mainstream supervisory frameworks. As a result, stress tests looking out to 2030 are intellectually satisfying, but remain largely theoretical exercises.

We seek to begin to fill this gap by suggesting a framework for what long-term financial supervision could look like that would allow for the integration of these long-term risk assessments, as well as the steering of policy levers beyond business cycle risk management. This requires a review of both existing and potential new policy instruments, as well as more general questions over how such policy could work (including related to the arbitrage between short-term and long-term risks).

The primary output of our research will be a discussion paper focused on two central questions:

  • What are the instruments to enhance the supervision of long-term risks?
  • How might governance and mandates need to change to support the supervision of long-term risks?

1in1000

This new research program that aims to integrate future risks and challenges, notably those related to climate change, ecosystem service loss, and social resilience, into financial processes and regulations. The program will act as host to 2DII’s research and partnerships with financial institutions, central banks, NGOs, academia, and financial policymakers on three key areas:
– Developing performance standards and metrics to define what is a ‘long-term investor’ and a ‘long-term bank’;
– Designing risk management tools and frameworks to quantify climate change-related risks and related issues, notably ecosystem service and biodiversity loss, and threats to social cohesion & resilience;
– Building capacity, policies, and incentives to help financial institutions and supervisors mitigate and adapt to future risks and challenges.

Financial Supervision beyond the Business Cycle. Towards a new paradigm

At the turn of the decade, a specific class of risks are coming increasingly into focus – long-term risks (LTRs). Pandemic, climate change, and social resilience represent major threats both to economies and sound and stable financial markets. This paper explores both the extent to which these types of risks are on the radar of financial supervisors and central banks, and mechanisms to drive financial supervision “beyond the business cycle”.

To this end, the paper reviews over 2,000 speeches, reports, and press releases as well as other public documentation such as Financial Stability Reports across eight major central banks (CBs) in the Global North & South. It presents an audit of the risk management activities of the eight central banks – categorized into measuring, monitoring and mitigation activities – and comes to the following conclusions:
Most quantitative measuring activities – in the form of stress testing – do not extend beyond the business cycle. The focus of those CBs that include LTRs is limited to climate change, and the regulatory use of climate stress tests remains unclear.
Monitoring of LTRs – tracked through Financial Stability Reports – is mostly backward and not forward-looking. The most monitored risks are those LTRs that recently materialized, such as Covid-19.
Mitigation policies, such as decarbonizing monetary policy, or setting green capital requirements rarely consider LTRs. Even though we argue that mitigation policies are the most important step of risk management, CBs – in particular CBs of the Global North – do not have mitigation policies in place that included LTRs.
The way forward:
Having identified long-term risk management gaps, the paper takes a step back and discusses a required shift in thinking needed to address these gaps.
As for the required shift, the paper calls for capacity-building – such as implementing precautionary measures and supporting effective policy coordination – in order to better prepare for long-term risks.