Climate-related systemic risks and macroprudential policy

Climate-related systemic risks and macroprudential policy

Climate change has a clear systemic dimension: its consequences are not only widespread across all sectors and regions, but potential concentrations, spillovers and interlinkages within the financial system risk further amplifying its economic and financial impacts. The systemic nature of climate change for financial stability suggests the need for a macroprudential response that goes beyond a (microprudential) focus on individual firms and ensures a consistent approach across the financial system.

While climate change may be predictable, the timing of its financial impacts is uncertain. Therefore, central banks and financial supervisors must rapidly develop sound risk management practices adapted to a context in which policy decisions rely on imperfect data and high uncertainty.

Existing macroprudential policy toolkits can be deployed now to address climate-related systemic risks with some possible adaptations to reflect the unique features of climate-related risks, like the long time horizon over which they may materialise, their strong dependency on the speed and direction of the low-carbon transition, and the specific data and forward-looking measurement methodologies required to manage them.

Two possible instruments that can be tailored to address systemic climate-related financial risks are: (i) ‘systemic risk buffers’, to increase the resilience of the financial system to climate-related shocks and contribute to mitigating the build-up of future risks; and (ii) measures limiting exposure concentrations, which could target and thereby mitigate sources of risk where they are greatest. While there are undeniable challenges in devising these macroprudential responses to climate-related systemic risks (e.g. modelling complexity and uncertainty, partial data coverage), the risks will only increase with inaction. This points to the need for central banks and financial supervisors to adopt a forward-looking approach and progressive deployment of policy in their response to climate risk.

Authors

Paul Hiebert

European Central Bank
Publisher

SOAS Centre of Sustainable Finance, LSE Grantham Research Institute on Climate Change and the Environment

Published August 8, 2023