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N.B.: This text features extracts from the Finance Watch report “A silver bullet against green swans”
Leading regulators, supervisors and researchers from around the world have long recognised the financial stability implications of climate change and the financial nature of climate-related risks. Financial stability is at risk, as climate change-related extreme events will disrupt our ecosystems, infrastructures, supply chains, impact human health and mortality. These events will, in turn, lead to massive and abrupt devaluations of assets and collateral held by financial institutions, unexpected price swings and market movements affecting the whole spectrum of financial risks across our financial system.
Climate-related financial risks have specific features, which pose significant challenges when it comes to deploying existing prudential tools and approaches to tackle them. Specifically:
Disruption risk: Climate-related events are defined as “green swans” and have specific features, which makes them impossible to predict and model. In particular, green swans are characterised by: i) certainty of their occurrence despite highly uncertain impacts and the impossibility to determine the exact timing of their materialisation; ii) wide-ranging and existential impacts on the economy and the financial system; iii) a high degree of complexity, including cascade effects and chain reactions in the environment, economy and society.
Probabilities of climate-related events not reflected in past data: Traditional risk modelling based on historical data is not possible as we are dealing with a forward-looking phenomenon, for which no past data can be used reliably to extrapolate the future. By definition, when the data eventually arrives, it will be too late to avert a global climate change-induced financial crisis.
Growing risk with prolonged inaction: The magnitude and probability of climate change materialisation are increasing as long as no tangible actions are taken to reduce greenhouse gas emissions. Once global temperatures have exceeded their pre-industrial level by 2°C, the consequences on human society and the global economy will be irreversible and largely unpredictable.
The time horizon of climate-related financial risks materialisation can be significantly longer than the horizon of the current business forecasting, planning and risk management frameworks. This poses additional challenges for financial institutions to appropriately incorporate CRFR into their management practices.
Environmental stability, including climate, is by nature a public good, which comes at no cost to private agents. Coupled with the long materialisation horizons of climate-related financial risks, this means that businesses and financial institutions do not have incentives to consider the implications of their activities for the environment/climate. Looking after public good is the mission of governments/regulators, not private agents.
The role of prudential policy is to ensure that climate-related financial risks are identified and appropriately managed by financial institutions. In this respect, views on the most appropriate prudential measures are widely divergent. Different prudential solutions exist to incorporate CRFR into the existing prudential frameworks and in particular into risk management processes. Pillar II measures have been the focus of this debate lately and this article looks into their role.
Under Pillar II, banks and insurance companies are obliged to establish risk management processes and assess the adequacy of their capital to cover all the risks they can potentially face in the course of their business, which includes solvency. Supervisory authorities then conduct their review and assess institutions’ risk profiles from four different angles: (i) business model, (ii) governance and risk management, (iii) capital and (iv) liquidity. Based on this assessment, institutions are required to maintain additional capital (Pillar II add-on) for risks that are not covered by minimum regulatory capital requirements under Pillar I.
Advocates of Pillar II prudential measures as a tool to address CRFR argue that financial institutions are best placed to assess and manage their risks, including CRFR. According to them, this can be achieved specifically via[1]:
Whilst Pillar II measures are an important element of the institutions´ own risk management process, significant challenges need to be resolved before these measures can lead to effective and impactful outcomes in managing CRFR, which means that the measures are unlikely to come in time to prevent major CRFR from materialising...
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