New report on the false sense of security in climate risk models

In a new report published this week, Finance Watch is proposing a way forward to integrate science-based metrics in banks’ risk monitoring framework and address climate-related systemic risk to preserve financial stability in a warming world. The author of the report is Thomas Larible.

Report – Towards a climate-resilient banking sector

Climate change is an increasingly systemic threat to the financial sector, but its non-linear features continue to defy banks’ traditional risk modelling. In this report, Finance Watch proposes a new, complementary approach to address climate risk in the banking sector and preserve financial stability in a warming world.

Current prudential approaches give a false sense of security

Banks are dangerously exposed to the financial impacts of climate change. To mitigate these risks, authorities in charge of financial stability have so far relied on microprudential tools and explorative scenario analyses. But such tools cannot currently capture the full characteristics of climate risk (radical uncertainty, irreversibility, non-linearity, temporal interdependence). With climate change, traditional risk models provide reassuring numbers that fail to predict losses reliablyand fuel inaction.

Shifting from reactive risk management to managing uncertainty

Meanwhile, climate-related systemic risks keep building up. Rather than waiting for “perfect data” to act, authorities must move from a reactive stance to proactive management of uncertainty. The report shows how, by monitoring early warning signals from climate science, supervisors can incorporate new metrics – such as global warming trajectories, deviation from Net Zero trajectory, and locked-in greenhouse gas emissions – in their risk monitoring framework to capture looming vulnerabilities that traditional metrics completely miss.

A dedicated climate macroprudential capital buffer

Crucially, Finance Watch proposes to complement the current supervisory approach with a new macroprudential tool (compatible with international and European banking rules) to address the systemic dimension of climate risk. Implementing this capital buffer, calibrated on science-based metrics, would increase the resilience of the banking sector by:

• building additional loss-absorption capacity against underpriced transition risk and physical risk;
• preventing the build-up of systemic climate-related risks.

The report is available here.

External link