Even those who still do not believe that climate change is a serious threat to our way of living will need to pay attention: it could turn out to be the next Black Swan for financial markets.
Banking is probably not the first industry that comes to mind when thinking about the risks of climate change, but it could suffer massively from its effects – and with it, the whole economy.
At the very least, climate change risk is likely to increase costs for bank clients, be they corporate or private, as the lenders will need to somehow find the resources to cover higher provisions.
The banks have already started to incorporate climate change risks into their models, but with so many unknowns about how these could manifest, uncertainty about the costs is high and rising.
A recent paper by the Bank for International Settlements (BIS) outlines the extent of the challenge.
It quotes data by reinsurer Munich Re that show the losses from natural disasters at a global level were $5.2 trillion between 1980 and 2018, of which almost 60% were meteorological and climatological disasters.
With these set to increase as climate change accelerates, banks’ exposure could mean that the impact on the economy could be much more severe than just on the traditional industries that feel the effects of climate change.
The climate-related risks are included in the risks that banks already monitor, according to the BIS paper. These are: credit risk, market risk, liquidity risk, and operational and reputation risks.
If credit risk – the risk that clients default – and liquidity risk – the risk the banks will have difficulty selling the collateral backing their loans – can be relatively easily measured, market risk comes with big uncertainty.
The BIS paper defines market risk as the “reduction in financial asset values, including the potential to trigger large, sudden and negative price adjustments where climate risk is not yet incorporated into prices.”
Correlations between assets could also break down if there is a big market shock, and market liquidity for particular assets could reduce. This would undermine the assumptions made by banks’ risk management strategies, rendering them worthless.
Typically, banks have managed market risk and limited their exposure to systemic shocks by analysing historical market data.
But, the BIS paper argues, “the unprecedented nature of climate risk drivers and the opacity of climate-vulnerable exposures makes asset mispricing and the risk of downward price shocks particularly salient.”
If, how and to what extent investors price in climate risks when valuing a financial asset is unclear, and equally so is how much the extent to which climate change risks are priced into asset values affects the solidity of the banking system as a whole.
Even though the language of the paper is prudent, the warning is stark: a climate change shock could mean not just a localised natural disaster, but a global economic one.
The 2007-2009 financial crisis has shown that the collapse of one bank is never confined within the borders of one country. Perhaps climate change will be the next Black Swan for markets.