From Covid-19 to climate change and nature loss: how can a precautionary financial policy framework coordinate monetary, prudential and fiscal policies to address long term challenges?

In the face of climate-related financial risks, the Bank of International Settlements in its ‘Green Swan’ book demonstrated the importance of coordination between green fiscal policy, prudential regulation, and monetary policy. Such coordination must be underpinned by a shift in intellectual framework to facilitate financial policymaking under unprecedented global threat situations.

Aligned with this assessment, we propose to develop the Precautionary Financial Policy (PFP) framework, to address the dual issues of policy coordination and the need for an underlying paradigm shift. The PFP framework provides the theoretical justification for more ambitious financial policy interventions, in the face of the radical uncertainty characterizing long-term and potentially irreversible risks such as those posed by climate change and massive biodiversity loss.

The project will develop the PFP framework as a new paradigm that could support greater coordination between monetary, prudential, industrial, and fiscal policies (henceforth financial-fiscal) in the face of emerging climate- and nature-related financial risks. In particular, we will examine:

  • How this approach may provide a more coherent alternative than the ‘market neutrality’ principle in facilitating such coordination, in light of the recent European Central Bank’s declarations questioning this principle, and
  • How the PFP could help to deal with the problem of differing time horizons across policy spheres, institutions, and mandates that also mitigates against policy coordination.

The research will involve analysis of historical examples since the 1930s up to and including the most recent policy responses of financial-fiscal policy coordination and expanded institutional purpose to address Covid-19. We will develop a typology of financial-fiscal policy coordination and use this to formulate concrete policy recommendations in terms of institutional setup and governance.

Finance, climate-change and radical uncertainty: Towards a precautionary approach to financial policy

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy framework for dealing with them has largely focused on market-based solutions that seek to reduce perceived information gaps that prevent the accurate pricing of CRFR. These include disclosure, transparency, scenario analysis and stress testing. We argue this approach will be limited in impact because CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. In addition, this approach tends to bias financial policy towards concern around avoiding short-term market disruption at the expense of longer-term, potentially catastrophic and irreversible climate risks. Instead, an alternative ‘precautionary’ financial policy approach is proposed that offers an intellectual framework for legitimizing more ambitious financial policy interventions in the present to better deal with these long-term risks. This framework draws on two existing concepts — the ‘precautionary principle’ and modern macroprudential policy — and justifies the full integration of CRFR into financial policy, including prudential, macroprudential and monetary policy frameworks.