Climate change could provoke a global financial crisis and regulators are on-notice and taking action

• Financial stability risks are harder to detect without data on climate-related financial risks, which has made this a top priority for regulators
• A realization of physical risks could accelerate transition risk, with an amplifying effect on climate-related financial stability risks, slower growth, and reduced financing growth
• FSB sees cross-border exposures as a force for global financial stability, but for recipient countries of cross-border financing it could amplify climate-related risks

The Great Financial Crisis of 2007–2009 was a transformative event in the financial sector. Some of the regulatory changes introduced since then have provided resiliency during the Covid pandemic, which has prevented economic challenges from spiraling into a wider financial crisis. Following the success in preventing what could have been a worse crisis, the Financial Stability Board (FSB) has released a report looking at how to manage the climate-related risks on the horizon.

In many respects, the Great Financial Crisis was an easier challenge to remedy because it was exposed by weakness in one small segment within the financial system that spilled over into housing market weakness and exploded into crisis because of liquidity shortages and lack of transparency about exposure to toxic assets.

Climate risk exposures exploit some of these same risks, such as non-transparency about exposure, which are more intractable. The FSB describes how “incomplete/asymmetric information about exposures can give rise to contagion where different sectors or intermediaries are bundled together by other market participants due to a lack of information to properly differentiate across counterparties.” Financial institutions can report more easily on their own direct emissions, but rely on their customers’ reporting being accurate and consistent to report financed emissions in a way that is comparable across the financial sector.

With a patchwork of companies now reporting in line with the FSB’s Task Force on Climate-Related Financial Disclosures (TCFD), especially in emerging markets, this means the necessary information is only beginning to be created. Companies and financial institutions will have to make TCFD reporting more ubiquitous and use comparable scenarios based on robust data if they are to fix the transparency gap in where risks are concentrated. (We have provided a top-down estimate of financed emissions for Malaysia in our latest report.)

These data challenges are being pushed up the agenda, with climate stress testing now intended by the Bank of England and Banque de France, as well as climate scenarios for regulators and central banks from the Network for Greening the Financial System (NGFS). Last week, the board of the International Organization of Securities Commissions (IOSCO) agreed to support work by its Sustainable Finance Task Force on developing pathways to mandatory sustainability disclosures, consult on the IFRS Foundation’s proposal for sustainability disclosure standards, and development of an assurance framework for sustainability disclosures.

The push towards increased disclosure requirements is accelerating among regulators. Many financial institutions are not investing enough to prepare themselves or their customers to get ahead of mandatory reporting. But it won’t stop with just disclosure. Climate-related risks are significant and will require mitigation and adaptation efforts to reduce risk exposure. Some of the most consequential impacts of climate change could work in tandem and each make the others’ impact more destabilizing.

For example, increased materialization of physical risks could lead to a policy response that provokes “a disorderly transition to a low-carbon economy, unanticipated by market participants, [which] could have a destabilizing effect on the financial system”. The physical risk realization which provokes such an impact could also influence the availability or pricing of insurance coverage, which would expose financial institutions to more risk.

If the response to seeing insurance coverage withdrawn is to reduce the financing offered, this could have a compounding economic impact by slowing the recovery from a climate-related disaster. In addition, by reducing the ability for insurance companies to absorb some risks, the resulting exposures in the financial system will be more pro-cyclical and harder to manage without reducing the financing available to the real economy. This added pro-cyclicality of risk appetite would come as physical and transition risk realization becomes more correlated across economies and sectors.

The FSB saw some evidence that international linkages in the financial system would act more as a stabilizing force in response to climate-related impacts. However, this effect would be more pronounced in relation to global financial stability. The FSB cautioned that recipient countries of cross-border financing could see the “crystallisation of physical risks [prompting] the large-scale withdrawal of funding from foreign investors.”

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