Misleading economic models increase the risk of a climate financial crisis

Misled into the storm by “overly-sunny” economic forecasts

Imagine a massive ocean liner – the global financial system – preparing to cross an ocean. The weather forecast predicts a bit of choppy water, but nothing the ship can’t handle. However, there is a hidden problem: the computer model used to create that forecast only looks at past storms. It is physically incapable of seeing the “Green SwansThe Green Swan concept refers to highly disruptive financial events caused by climate change. Inspired by Nassim Nicholas Taleb’s idea of a “black swan” — unexpected events with major consequences understood only in hindsight — a Green Swan specifically describes climate-related financial shocks. It comes from the book The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, published by the Bank for International Settlements. https://greencentralbanking.com/research/the-green-swan-central-banking-and-financial-stability-in-the-age-of-climate-change/” – the hurricanes that scientists warn are building just over the horizon.

Even as scientists repeat that the current direction of travel leads the ship into a storm much bigger than it can handle, the forecast remains “benign”. Economists are hard at work to improve forecasting tools but by the time the forecasts are robust enough (and economic models reliably reflect climate science), the ship will have advanced too far into the storm (the build-up of climate risk across the financial system will have far exceeded its capacity to withstand a “climate Minsky momentA climate Minsky moment is a Minsky moment - a sudden, catastrophic collapse of asset valuation - caused by a Green Swan. To learn more about Minsky moments, read https://www.tutor2u.net/economics/blog/hyman-minsky-the-financial-instability-hypothesis?srsltid=AfmBOop5-bWHV63ozPqo20gdBTJZ-0g7WUNd1Uu3j5Ct3CMWlsAnnNS-”). The only way to save the ship is to avoid the eye of the storm in the first place with an early – preventive – change of course.

Financial markets on course for a hurricane

Climate change is already an imminent danger for the financial system. In the next five years, extreme weather events could put up to 5% of the euro area’s economic output at riskThis is according to the new short-term scenarios of the Network for Greening the Financial System (NGFS), see https://www.ngfs.net/en/publications-and-statistics/publications/ngfs-short-term-climate-scenarios-central-banks-and-supervisors. In just 25 years, climate risk could cost the global economy $23tn annually, slashing global economic growth by between 11% to 14% according to estimates by global insurer Swiss Re. A report by the Institute and Faculty of Actuaries (among the most conservative and data-driven financial professionals in the world) predicted that the global economy could face a 50% loss in GDP between 2070 and 2090 from catastrophic climate shocks, far higher than previously estimated.

And these figures are conservative, based on economic models which are unadapted to reflect the phenomenon of climate change. At odds with climate science, these models fail to account for tipping pointsClimate tipping points are critical thresholds in the Earth’s complex climate system where small, gradual changes — such as rising CO₂ or shifts in albedo — can trigger large, abrupt shifts due to feedback loops. Once crossed, these thresholds can lead to major and often irreversible changes, preventing the system from returning to its previous state., rising sea levels, compound risks, system-wide amplification effects and the disruptions that will emerge from the materialisation of societal risk, such as climate-related conflict and mass migration. The truth is: the financial system’s real exposure to climate risk is still largely unknown.

What is a “climate-driven financial crisis”?

What is known is this: the “climate scenarios” used by prudential authorities to model the impact of climate risk on financial institutions (the “weather forecasts”) understate the effects of climate change by a large margin. Central banks recognise this, while a report drawing on a survey of 68 climate scientists, confirms it. Massive financial damage can materialise suddenly, and financial institutions are not ready for it.

The last time that a significant amount of hidden risk suddenly materialised (the subprime crisis in 2008), it ended up costing Europe a decade of growth and trillions in taxpayers’ money – which citizens are still paying for. And the financial system is still vulnerable.

The 2008 post-crisis “never again” financial reform agenda has been significantly watered down while some of the risk has been transferred to the under-regulated shadow banking sector. Recently, a relatively small shock triggered the 2023 banking crisis in the US resulting in several bankruptcies in the American banking sector which forced the Federal Reserve to intervene massively. The sudden fall of the banking giant Credit Suisse (whose solvency ratios and liquidity ratios were substantially above what current regulations require) was another recent warning shot.

In this context, prudential authorities already consider the fast growth of unaccounted climate risk as a potential trigger for the next big financial crisis – a “climate financial crisis”.

Don’t wait for the ship to sink: navigate with precaution

In this context, navigating with a “precautionary approach” means acting now based on the certainty of the direction of travel, even if the exact timing of the waves cannot be quantified. We don’t need a perfect model to know we need to stay away from the eye of the storm.

Immediate steps for a more prudent journey include:

• Using qualitative scenarios: Supervisors should complement quantitative metrics with evidence-based judgment from climate science that accounts for tipping points and potential breaking points for the financial system.
• Raising capital requirements: Regulators should require banks and insurers to strengthen their loss absorption capacities to address climate risk. This “cushion” would prevent a climate crisis from leading to another taxpayer bailout.
• Preventing the risk from growing: With the radical uncertainty of climate change and the difficulties in modelling its financial impact, supervisors should take measures to prevent the rise of climate risk through targeted macroprudentialSince the 2008 financial crisis and the fall of Lehman Brothers, supervisors have recognised that treating the financial system as merely the sum of its parts overlooks the system’s historical tendency to swing from boom to bust. The financial markets’ amplification effects resulting from interconnectedness, herd behaviours and spillover effects have proven to be very dangerous for the economy. Nowadays, the systemic dimension of financial stability is considered and supervisors have created tools to protect society against system-wide risks. “Macroprudential buffers” for instance, help shield the financial system from a bank’s risky exposures. They increase banks’ loss absorbing cushions and prevent the build-up of systemic risk in the system. measures.

Without a full picture of the losses that climate change could cause, the financial system is sailing blind. Supervisors cannot allow flawed economic models to provide an alibi for inaction. By adopting precautionary measures today, financial authorities can ensure the financial system is resilient enough to weather the coming storm and can support the economy in troubled times.

Pablo Grandjean, Finance Watch

Note:

The rules of finance are not set in stone, they are decided by people. It is up to civil society actors to convince decision makers to change them. The Finance Watch team works tirelessly towards the improvement of climate scenarios and the supervision of climate risk, but the context is challenging and any support is welcome. If you liked this article, please consider:

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