12 December 2023
This is the fifth post in our series accompanying COP28.
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.
Why a macroprudential approach is important
The discussion on the role and timing of a macroprudential response has just begun.[3] This is due primarily to uncertainty. Climate risks will eventually materialise, but their severity and form will depend on how climate change and the green transition unfold. While a wait-and-see approach might seem preferable until there is more clarity, this might delay action until it’s too late. Like other cases of systemic risk build-up, today’s underestimation of risks can result in capital misallocation and economic losses tied to the irreversibility of global warming. A macroprudential approach, aiming to reduce the accumulation of such risks, could counter this inaction bias through preventative (and not just corrective) action to contain financial risk.
Another challenge concerns the role of macroprudential policies in the broader policy mix. The progress made by microprudential supervisors and improvements in market participants’ risk management could lead to the misperception that no further action is needed. But this approach is not enough, because climate change will also likely affect risks that cut across the financial system, with financial risks that emanate from collective and not just individual actions. More frequent and severe weather events, for example, will make the negative economic impacts more volatile. Likewise, the transition to a low-carbon economy might be bumpy, with volatility around insufficiently prepared parts of the financial system. This may require additional resilience to account for the increase in system-wide risks that are currently not captured in the prudential framework for supervision of individual banks. Macroprudential policy would complement microprudential measures by both reducing risk build-up and increasing resilience against growing climate risks.
Analytical advances and the development of a shared monitoring framework have significantly improved our ability to understand and manage climate-related financial risks.[4] With the progress being made on the analytical side, developing a common EU macroprudential policy framework is both timely and possible.
Towards a common macroprudential strategy for climate risks
The 2022 ECB-ESRB Project Team report, The macroprudential challenge of climate change, looked at the possible macroprudential response and possible instruments to be used. The 2023 Project Team report will follow up by outlining a comprehensive common EU strategy for macroprudential policies to address climate risks, including a menu of specific policy options ready to be used when necessary.
The framework can use tools to address risks from a lender’s perspective (e.g. general or sectoral capital buffers, concentration thresholds), as well as from a borrowers’ perspective, or with tools targeting informational failures (e.g. enhanced disclosures). The complex and evolving nature of climate risks means an effective macroprudential framework also needs to be adjusted as the understanding of climate risks evolve: they may be scaled up if risks increase, and scaled down if and when risks recede.
The macroprudential response needs to be targeted, gradual and dynamic. The ideal response must prioritise aligning incentives with the prudential objectives. Imposing restrictive capital requirements indiscriminately may unintentionally hinder the financing of the green transition. Taking into account corporates’ forward looking transition plans could make macroprudential tools more efficient and limit possible side effects.
A common framework is key to ensure a consistent policy response. Close coordination across jurisdictions at the European level and beyond will be crucial to maximise efficiency.
Macroprudential policies can complement microprudential policies and ensure that the financial system is robust and resilient in the face of climate-related financial risk. By doing so, they will also ensure that the financial system is able to fulfil its role of financing the economy and the transition to climate neutrality. And, as highlighted in the ECB’s recent second economy-wide climate stress test exercise, the sooner and faster we complete the necessary green transition, the lower the overall costs and risks.
The views expressed in each blog entry are those of the authors and do not necessarily represent the views of the European Central Bank and the Eurosystem.
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