We are living in an era of systemic risks that will be defined by our our response to climate and biodiversity issues

• The Great Financial Crisis that began in 2007 was the beginning of the era of systemic crises
• Escalating risks relating to climate change and biodiversity issues will become the ‘new normal’ rather than an exception
• Financial institutions are not ready yet to measure their risks or respond but regulators are moving quickly so financial institutions should start to act

The Great Financial Crisis was a watershed moment in ways that are only becoming clear in hindsight. For one, it may have been the first in a series of systemic crises that will force financial institutions to focus much more on their resilience than other factors. Escalating risks relating to climate change and biodiversity issues, as well as the continuing fallout from the coronavirus pandemic, will become the ‘new normal’ rather than an exception.

Financial institutions concerned about maintaining and expanding their investor and customer base, and being in the best position to manage future regulatory changes, will need to learn more about their own exposures than is possible with the data they collect today. In the lead-up to the 2007–2011 financial crisis that began in US subprime and ended up in European sovereigns, the biggest concern was finding (or creating) new sources of yielding safe assets within the rules set down by ratings agencies.

The ratings relied on historical experience and gave a false sense of security as a result of the long period of moderation in financial markets and the economy. The ‘Minsky moment’ that spread the distress from a relatively small pocket of the financial markets — subprime loans — into a global crisis came from the hubris that previous experience wouldn’t re-occur on a global scale.

The emerging market debt crises of the 1980s and 1990s were caused by too much hot money flowing into markets that didn’t have the capacity to absorb it, and the speculative excess that these inflows created. Huge flows of capital into the United States weren’t expected to have a similar end, however, because the U.S. capital markets are so much larger, but the flows were large enough, for long enough, and with enough stability over time, to reach the point of saturation.

The triggering event for each type of crisis was something small that revealed that too much finance had been directed into places based on the assumption that the stability experienced in the past would inevitably continue into the future. The main difference with climate change, biodiversity and pandemics is that science is overlaid onto the behavioral factors that drove previous periods of stability leading to instability. The behavioral issues, such as herding, overconfidence and overleverage, are common in the lead-up to crises and are amplified in a world shaped by systemic risks that respond to and affect human behavior.

For example, cumulative greenhouse gas (GHG) emissions and atmospheric concentrations will produce climate instability in the future. Much of the impact is predictable in its statistical trends, but not for individual events, adding a new exogenous source of risks for financial institutions. However, the risks globally are correlated in the sense that many different types of risks (floods, droughts, severe storms) are rising in frequency. Humanity’s response to these events won’t necessarily be linearly related to underlying climate risks, which themselves could accelerate rapidly and unpredictably if tipping points are reached.

One of the key responses to these changes in climate that will affect the financial system as a whole is the policy response. The predictable aspects of climate science have led to the unprecedented global commitment under the Paris Agreement, which will again include all major economies after the U.S. rejoins on 20 January, 2021.

As we highlighted in the RFI’s recent report, the structure of the policy response in the Paris Agreement makes a significant policy tightening between now and the 2023–2025 period inevitable if the world wants to avoid the most adverse outcomes from climate change. This policy change will be far more significant and globally correlated than the changes to currency pegs in the 1980s/1990s, or the rise in Federal Reserve policy rates in the mid-2000s.

It is likely to overlap or be related to other major systemic changes, such as events that trigger a much closer focus on the value of biodiversity lost and its impact on humanity (including a greater frequency of pandemics as well as loss of critical natural capital). As we found in our research assessing the financed emissions risk facing Malaysia’s financial system, the level of risk itself is under-analyzed, which sets measurement as the first challenge, before risk management can be addressed.

A similar lack of preparation globally was found in the Task Force for Climate-related Financial Disclosures 2020 Status Update (fewer than 1-in-15 asset managers had measured the resilience of their strategies under different climate scenarios) as well as with public banks and development financial institutions on their biodiversity risk ($3.1 trillion of their $11.2 trillion of assets is financing projects highly dependent on vulnerable ecosystems).

These are global issues, and there are global forums created to help provide some direction (like the TCFD and prospective TNFD), but the issues involved are too numerous to be covered effectively at a global level. The direction from that level is clear about what the risks are, what actions are necessary to address the risks, and what the consequences are of failure.

The problems often seem too big to be dealt with at the national level alone, which makes it even more important to build links internationally while focusing on common, practical issues facing financial institutions and investors in responding. The RFI Foundation has set out its niche as the first nonprofit organization focused clearly at the connection between responsible and Islamic finance working to highlight solutions for how to build resiliency in the era of systemic risk.

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