Federal Reserve Bank cites climate risks in Financial Stability Report, for the first time

Monday, November 16, 2020

On November 9, 2020, the Federal Reserve Board issued its latest Financial Stability Report, which for the first time addresses the threat of climate change to the stability of financial systems. 

Twice per year, the Federal Reserve Board issues a Financial Stability Report summarizing the Board’s framework for assessing the resilience of the U.S. financial system and presenting the Board’s current assessment “to promote public understanding and increase transparency and accountability for the Federal Reserve’s views on this topic.” The 80-page report released in November includes a section, “The Implications of Climate Change for Financial Stability”, featuring discussion of how climate risks affect the stability of the U.S. financial system:

Opacity of exposures and heterogeneous beliefs of market participants about exposures to climate risks can lead to mispricing of assets and the risk of downward price shocks. Similarly, uncertainty about the timing and intensity of severe weather events and disasters, as well as the poorly under-stood relationships between these events and economic outcomes, could lead to abrupt repricing of assets. Climate risks thus create new vulnerabilities associated with non-financial and financial leverage. In regions affected by severe events, households and businesses could become overlevered if the value of their assets or income prospects become impaired. Levered financial institutions may be exposed to losses from disasters made more likely by climate change that are not accurately reflected in current financial models; for example, financial models may lack sufficient geographical granularity to accurately connect local physical damages to financial exposures. The financial system is also vulnerable to amplification effects of these damages if contracts are incomplete and do not capture all damages and if poorly understood financial exposures cause spillover effects or financial contagion. 

Within the financial system, increased transparency through improved measurement and disclosure could improve the pricing of climate risks, such as an increase in the frequency and severity of extreme weather events, thereby reducing the probability of sudden changes in asset prices. Continued research into the interconnections between the climate, the economy, and the financial sector could strengthen knowledge of transmission, clarify linkages and exposures, and facilitate more efficient pricing of risk. Outside the financial system, efforts to mitigate or adapt to the physical effects of climate change through technological advances and policy changes could also reduce climate risks in the long run.

The report also included illustrations of how climate risks can affect financial systems:

In a parallel statement, Federal Reserve System Governor Lael Brainard addressed the issue:

I welcome the introduction of climate into the FSR. Climate change poses important risks to financial stability. A lack of clarity about true exposures to specific climate risks for real and financial assets, coupled with differing assessments about the sizes and timing of these risks, can create vulnerabilities to abrupt repricing events. Acute hazards, such as storms, floods, or wildfires, may cause investors to update their perceptions of the value of real or financial assets suddenly. Chronic hazards, such as slow increases in mean temperatures or sea levels, or a gradual change in investor sentiment about those risks, introduce the possibility of abrupt tipping points or significant swings in sentiment. Supervisors expect banks to have systems in place that appropriately identify, measure, control, and monitor their material risks, which for many banks is likely to extend to climate risks. At present, financial markets face challenges in analyzing and pricing climate risks, and financial models may lack the necessary geographic granularity or appropriate horizons. Increased transparency through improved measurement and more standardized disclosures will be crucial. It is vitally important to move from the recognition that climate change poses significant financial stability risks to the stage where the quantitative implications of those risks are appropriately assessed and addressed.

Through the report, the Federal Reserve did not directly require banks to plan for climate-related shocks, but it did express an expectation that banks will “have systems in place that appropriately identify, measure, control, and monitor all of their material risks, which for many banks are likely to extend to climate risks." 

The Financial Stability Report follows the September 2020 report by a Commodity Futures Trading Commission subcommittee which identified climate change as a "major risk" to financial system stability.

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