12 December 2023

ECB blog: Climate risks, the macroprudential view

Climate change can endanger financial stability. The ECB Blog looks at how a common macroprudential policy framework could complement microprudential initiatives to make the financial system more resilient

Catastrophes caused by climate change, such as rising sea levels or more frequent extreme weather events, will harm our economies. And this will put a strain on the finances of people, companies and governments alike. Because of the risks to individual banks, banking supervisors have already taken steps to enhance how banks identify, assess and manage these institution-specific risks.^[1] Such supervisory measures are necessary steps focusing on the risks that climate change may pose to individual banks.

But climate change is also a risk to the broader financial system. The last two decades’ financial crises showed how the build-up of system-wide risk can erupt into costly turmoil. A timely macroprudential policy response is vital to strengthen the system’s resilience to climate-related risks.

Climate change as a systemic risk

Because of their unique nature, climate-related risks are likely to represent a systemic risk.^[2] First, the impact of climate change is irreversible. Unlike the economic and financial losses caused by conventional business cycles, rising sea levels, changing precipitation and the loss of arable or liveable land cannot be reversed. Second, the breadth of physical and transition risks mean they might simultaneously and unpredictably affect a significant share of financial institutions across sectors and/or countries.

While financial exposures to climate change are concentrated, they are not isolated. It has been clearly established that climate risks are highly concentrated. For example, high-emission sectors are over 70% of corporate lending of euro area banks. They are also expected to account for two-thirds of banks’ losses in the transition to a lower-carbon economy. These losses are unlikely to be isolated and contained.

Disruptions resulting from climate change are likely to spread along global production value chains and through financial portfolios. For example harder-to-diversify risks will result in a growing insurance protection gap. That could create a negative feedback loop: banks might be reluctant to grant loans to households and companies in vulnerable areas or industries, which in turn might worsen the local ability to adapt to a changing climate....

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Authors: Ludivine Berret, Jean Boissinot, Marianna Caccavaio, Michael Grill, Paul Hiebert and Fabio Tamburrini

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