Climate risk and financial stability in the network of banks and investment funds

By Alan Roncoroni (UZH),  Stefano Battiston (UZH), Luis Onésimo Leonardo Escobar Farfán (BdM), and Serafin Martinez Jaramillo (CEMLA).

Current version of the paper
 

What are the effects on financial stability of the interplay between climate policy shocks and market conditions?

To answer this question we combine the frameworks of the Climate Stress-test with the framework of the network valuation of financial assets and common asset contagion involving not only banks but also investment funds.

Captions. The infographic illustrates the climate envelope scenario analysis, i.e. the losses (as a percentage of initial total assets) suffered by the mexican financial. The x-axis represent the year of the disorderly transition towards climate targets. The y-axis represents the relative shock suffered by financial institutions. With filters, the user is able to select among the four different climate policy scenarios, as well as to set the range for the market conditions (recovery rate and market volatility). Further, it is possible to observe the losses in the five stages of the contagion dynamics: 1) initial losses on the asset classes, 2) the losses due to direct exposures (first round), 3) the losses due to direct contagion in the interbank network (second round), 4) the losses due to indirect contagion (third round, asset firesales), and 5) the losses that are too large to be absorbed by banks' capital and are thus transferred to external creditors (fourth round). Notice that stages are cumulative (i.e. fourth round includes third round).

The extended bank-fund climate stress test. In this paper we extend the models of financial contagion to derive the first climate stress-test methodology that combines an ex-ante valuation of financial assets, an endogenous recovery rate and a fire-sales reaction that consider several types of financial institutions at the same time. The dynamics of contagion can be summarized as follows:

• Climate policy shocks: we estimate the impact of the late and disorderly alignment to a climate policy (building on LIMITS, i.e. estimation of the evolution of the output of different sectors of the real economy in different policy scenarios).
• First round: losses due to direct exposures.
• Second round: ex-ante valuation of intra-financial banks' assets which includes an endogenous recovery rate.
• Third round: banks' and funds' liquidation to get to their initial risk management.
• Fourth round: losses that are too large to be absorbed by banks' capital and are transmitted to external creditors.

Policy implications. Our results have three main policy implications.

• If the alignment of the real economy to climate targets cannot be avoided to be disorderly, then financial institutions have an incentive for such an alignment to occur as early as possible.
• A country could reach a more stringent climate target, if the alignment occurs earlier, at the same cost (in terms of financial losses) of reaching a less stringent target with a later alignment.
• It is possible to contain the adverse effect of financial contagion if the market conditions are strengthened enough.

Keywords: financial stability, climate risk, sustainable finance, climate stress-test, low-carbon transition risk, 2°C opportunities.