Should disaster risk and climate change be introduced in macroprudential regulation and supervision?

Should disaster risk and climate change be introduced in macroprudential regulation and supervision?

Gregorio Belaunde, Independent Risk Management Consultant

Should central banks care about climate risk?

When the new President of the ECB, Christine Lagarde, said on December 2, 2019 that fighting against climate change was a critical mission for the ECB, she was met with comments that this not being ECB’s mandate and that it could even affect its independence. According to Jerome Powell, Chairman of the U.S. FED, climate change is not a job for the Bank. Similarly, for a long time, the Basel Committee on Banking Supervision (BCBS) did not seem to think that it had a role to play in this field as a standards-setter.

The debate is rapidly moving, however. Mark Carney, while at the helm of the Bank of England and of the Basel-based FSB led efforts to include climate change as a key issue for central banks and financial regulators. This inspired the creation in December 2017 of a group of central banks and supervisors, the Network for Greening the Financial System (NGFS), which issued in April 2019 a Call for Action with, as 1st Recommendation, “Integrating climate-related risks into financial stability monitoring and micro‑supervision”. The BCBS joined this network in June. In its October 2019 Global Financial Stability Report the IMF mentioned climate change as a key issue, just after joining the NGFS. This January, the BIS released its first paper on this, a book called “The Green Swan”, where it states that “Central banks can have an additional role to play in helping coordinate the measures to fight climate change”. So, the answer to the question laid out at the beginning is now a clear Yes. This said, both the IMF and the BIS stress that integrating climate change into financial stability monitoring is a significant challenge, due to radical uncertainties. So, the complete answer is rather: Yes, but how exactly?

I think that the problem is even more relevant and urgent for emerging and developing countries and their financial regulators/supervisors, in coordination with Ministries of Finance due to their fiscal risk management role. This particular relevance stems from the fact that the impacts of climate change and related hazards on their GDP, and therefore on the quality of the credit exposures, are inevitably much higher, given the smaller size of their economies, as international experience shows. Concurrently, those countries should not forget that the problem is not only climate change, but also disaster risk, which considers a broader range of events than weather-related ones, notably earthquakes. This has been reminded in a Standard and Poor’s study of 2015 about the impact that “natural” disasters could have on sovereign ratings, and in different studies concerning the serious “disaster-insurance gap” that those countries face. Both factors combined can cause steep increases in non-performing loans (NPLs), with a systemic impact if several significant disasters hit in a short period of time, or in case of a large-scale disaster.

Therefore, the financial regulators/supervisors should urgently integrate climate change and disaster risk into their macro-prudential regulation and supervision, with a related translation into micro-supervision, in the same way as they include risks related to borrowings and loans in foreign currency, for instance. A broad range of very concrete measures can be adopted rapidly. These include, inter alia, and as those that should be prioritized:

  1. stress scenarios on credit exposures of financial institutions (FIs), based on simulations of large expected disasters or continued increased losses due to climate change, leading to possible additional Pillar 2 capital charges in case of need
  2. inclusion into the FIs rating and scoring systems of the evaluation of good and bad disaster risk management practices of their customers, including business continuity planning/disaster recovery planning (BCP/DRP) and degree of insurance uptake
    strengthening of regulation and supervision standards for BCP/DRP: more practice, more trials and tests, more “embedding” into the whole organization, stronger incorporation of country-relevant disaster risk scenarios
  3. more stringent provisioning requirements when insurance does not really protect the customer himself and is limited to the loan’s outstanding amount
  4. developing metrics, as part of financial stability reports, about evolution of disaster insurance penetration among FI’s customers

The challenges posed by the uncertainties of the impacts of climate change should not keep the regulators/supervisors from taking rapid steps to at least address in a systemic and preventive way the very real financial risks stemming from natural disasters, which have always existed and proved a substantial source of increased NPLs in the past, and are not limited to weather-related hazards. This should have been done before in a number of developing and emerging countries more heavily exposed to disaster risk. Climate change, with its potential to worsen frequency and impacts of hazards, as well as the rapid and disorderly urbanization with its rise in vulnerabilities and in potential impacts, only increase that urgency.

BIS (2020), “The Green Swan – Central banking and financial stability in the age of climate change”, Book – January 2020.
BIS (2019), Research on climate-related risks and financial stability: An “epistemological break”?, Speech by Luiz Awazu Pereira da Silva, 23 May 2019.
Carney, Mark (2015). “Breaking the Tragedy of the Horizon—Climate Change and Financial Stability.” Speech delivered at Lloyd’s of London, September 29.
Grippa, Pierpaolo; Schmittmann, Jochen and Suntheim, Felix (2019), “Climate Change and Financial Risk”, IMF – Finance and Development, December 2019.
IADB (2019), “Climate Risk and Financial Systems of Latin America – Regulatory, supervisory and industry practices in the region and beyond”. Technical Note No IDB-TN-01823. December 2019.
NGFS (2019), “A Call for Action – Climate change as a source of financial risk”, First Comprehensive Report, April 2019. Paris: NGFS Secretariat.
Reuters (2019), “ECB’s Lagarde will struggle to fulfill self-imposed climate mission”, Article 4 December 2019.
Standard & Poor’s (2015), “Storm Alert: Natural Disasters Can Damage Sovereign Creditworthiness”. Ratings Direct. September 10, 2015.
The Geneva Association (2014), “The Global Insurance Protection Gap—Assessment and Recommendations”. Research Report. November 2014.
UNISDR and CRED (2018), “Economic Losses. Poverty and Disasters, 1998-2017”.
Von Peter, Goetz. et al., “Unmitigated Disasters? New Evidence on the Macroeconomic Cost of Natural Catastrophes”. BIS Working Papers, No. 394, December 2012.
Webb, Ian, David Baumslag, and Rupert Read (2017), “How Should Regulators Deal with Uncertainty? Insights from the Precautionary Principle.” Bank Underground.
World Economic Forum (2019), “The Global Risks Report 2019”. 14th Edition.