Thematic Tags: Macro financial risks and macroprudential supervision

Macroeconomic implications of climate change and transition risks for central banking in the Global South – the case of Nigeria

The research sheds light on a largely under-researched topic: What effects do physical and transition effects of climate change have for central banking transmitted through the balance-of-payments in the Global South? We conduct a country case study of Nigeria by triangulating primary qualitative data generated from ten semi-structured interviews with secondary quantitative data. The latter is used in a time series analysis, where we built two structured Vector Autoregressive models. We find that physical and transition risks both impact Nigeria‘s balance-of-payments through the financial and current account channel to the detriment of the central bank‘s objectives. Long-term physical effects of climate change and the strong oil dependence of Nigeria‘s domestic economy, its financial system and trade balance play a major role. Central banking in Nigeria is adversely affected when climate risks reduce foreign exchange income and increase the need thereof; when they put pressure on the exchange and inflation rate and undermine the acceptance of Nigerian financial assets. As a consequence, the central bank will have to keep interest rates notoriously high. These effects have recessionary implications for the domestic economy and impede economic diversification and a green transition in Nigeria.

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.

Inclusive green finance: A new agenda for central banks and financial supervisors

Climate change and environmental degradation can have profound economic impacts, which may translate into micro- and macro-financial risks that need to be addressed by central banks and financial supervisors. Green finance and financial inclusion have mostly been treated by central banks and financial supervisors as two distinct and largely unrelated agendas, despite meaningful overlaps between these two areas. Key target groups for financial inclusion tend to be disproportionately exposed to the impacts of climate change and environmental degradation, while also playing an important role in adapting to and mitigating environmental change.

Against this backdrop, central banks and financial supervisors can combine green finance and financial inclusion policies in an integrated inclusive green finance (IGF) approach. By accounting for equity concerns in the design of green policies, this policy approach can avoid any potential adverse effects on economically vulnerable groups, and enable central banks and financial supervisors to foster a just transition to an environmentally sustainable economy.

Central banks and financial supervisors have various tools at their disposal to translate the concept of IGF into actionable policies. By bringing together the complementary aims of green finance and financial inclusion, they can help to improve the livelihoods of low-income households and the business prospects of micro, small and medium-sized enterprises (MSMEs) while simultaneously contributing to climate change adaptation and mitigation, minimising associated risks for the financial sector.

The instruments that central banks and financial supervisors can use to leverage IGF for climate change adaptation and mitigation can be divided into market-shaping [indirect] policies and direct interventions. A range of IGF policies have already been adopted by the banks and supervisors, and there are emerging examples of best practice.

Climate, Lives, Inequalities, and Financial Frictions

Climate change is expected to have increasing impacts on our economies and societies. The extent of such economic impacts has generally been analyzed with integrated assessment models. These models have substantially improved over time to account for various features that may lead them to underestimate the extent of climate damages. There is, however, in our view, one crucial feature that so far has not yet been accounted for: financial frictions. We consider that financial frictions may amplify the impact of climate damages on the affected economies, to an extent that has not yet been measured. Hence, the main goal of this project is to extend integrated assessment models of climate change to include financial frictions, to measure the possibility that physical risks, the impact on financial assets that arise from climate- and weather-related events, may lead to financial crises, and what measures may be introduced to limit such possibility. Further, to better assess the impact of such financial crises, which add to the direct effect of the climate- and weather-related events that trigger them, the integrated assessment model is conceived to include income categories, an important aspect too often neglected in this literature and necessary to account for inequalities in how climate damages may affect people’s livelihoods. The integrated assessment model is also conceived to include a widely used regional decomposition. The project aims to provide clear policy lessons, analyzing the impact of a wide range of policy levers, including financial institutions, macroprudential policy, insurance schemes, and adaptation efforts, and their ability to mitigate physical risks.

Greening capital requirements

Capital requirements play a central role in financial regulation and have significant implications for financial stability and credit allocation. However, in their existing form, they fail to capture environment-related financial risks and act as a barrier to the transition to an environmentally sustainable economy.

This paper considers how capital requirements can become green and explores how green differentiated capital requirements (GDCRs) can be incorporated into financial regulation frameworks.

Environmental issues can be incorporated into capital requirements using three different approaches: (i) microprudential approaches, which suggest that capital requirements need to be adjusted based on micro-level exposures to environmental risks; (ii) weak macroprudential approaches, which emphasise financial institutions’ exposure to systemic risks linked to specific sectors and geographical areas; and (iii) strong macroprudential approaches, whereby systemic risks are analysed through explicit consideration of macrofinancial feedback loops and double materiality. The use of microprudential and weak macroprudential tools can lead to an increase in physical risks at the system level – for example by undermining climate-vulnerable borrowers’ access to climate adaptation finance. According to strong macroprudential approaches, financial regulators should adjust capital requirements in a way that incentivises banks to support the ecological transition and economic resilience to climate change.

Green differentiated capital requirements (GDCRs), which can take the form of a green supporting factor (GSF) and a dirty penalising factor (DPF), are one of the tools that are consistent with the strong macroprudential approach. They can reduce physical risks, but they might have adverse transition effects if used in isolation. In the age of environmental crisis, strong macroprudential tools should play a prominent role in the greening of capital requirements. They need to be utilised in a way that is complementary with microprudential and weak macroprudential tools to minimise unintended adverse effects. If designed to accurately capture the environmental footprint of bank assets and minimise adverse financial side effects, GDCRs can contribute to the greening of the banking system and the reduction of systemic environmental risks. The positive effects of GDCRs can be enhanced if they are combined with other financial and non-financial environmental policy tools.

Greening collateral frameworks

Central bank collateral frameworks play a powerful role in contemporary market-based financial systems. Collateral rules and practices affect the demand for financial assets by financial institutions, with significant implications for governments’ and non-financial corporations’ access to finance. However, existing collateral frameworks lack environmental considerations and suffer from a carbon bias: i.e. they create disproportionately better financing conditions for carbon-intensive activities.

Environmental issues can be incorporated into collateral frameworks in a number of ways, notwithstanding various methodological and data challenges. We distinguish between (i) the environmental risk exposure approach, whereby credit assessments in collateral frameworks are modified to capture the exposure of financial institutions and central banks to climate-related financial risks, and (ii) the environmental footprint approach, in which haircuts and eligibility are adjusted based on the environmental impacts of financial assets. The two approaches have differing implications and design requirements.
We argue that the environmental footprint approach should be at the core of central banks’ green transformation of collateral frameworks. This approach contributes directly to the decarbonisation of the financial system, faces fewer practical challenges than the environmental risk exposure approach and does not penalise companies that are exposed to physical risks. It is also conducive to the reduction of systemic physical financial risks.

Central banks have a crucial role to play in developing a framework that will accelerate the collection and harmonisation of environmental data associated with financial assets. This will not only help to successfully decarbonise the assets of non-financial corporations included in the collateral framework but will also allow the expansion of greening to other asset classes, such as covered bonds, mortgages, corporate loans and asset-backed securities.