Climate Risk and Financial Stability in the Network of Banks and Investment Funds
60 Pages Posted: 8 Apr 2019 Last revised: 29 Jan 2021
Date Written: January 29, 2021
We develop a method to analyze the effects on financial stability of the interplay between climate policy shocks and market conditions. We combine the frameworks of the Climate Stress-test with the framework of the network valuation of financial assets, in which the valuation of interbank claims accounts for market volatility as well as for endogenous recovery rates consistent with the network of obligations. We also include the dynamics of common asset contagion involving not only banks but also investment funds, which are key players in the low carbon transition. We then apply the model to a unique supervisory data-set of banks and investment funds at the firm level in order to assess the impact for financial stability of shocks deriving from the disorderly alignment of energy and utility sectors in a range of climate policy scenarios. While under mild shock scenarios systemic losses are contained, we identify the climate policy scenarios and market conditions under which systemic losses can pose a threat to financial stability.
Keywords: financial stability, climate risk, sustainable finance, climate stress-test, low-carbon transition risk, 2°C opportunities
JEL Classification: D85, D86, E58, G01, Q54
Suggested Citation: Suggested Citation