Climate Stress Testing

48 Pages Posted: 10 Apr 2023 Last revised: 28 Jun 2023

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - New York University

Richard Berner

Leonard N. Stern School of Business, NYU

Robert F. Engle

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); New York University (NYU) - Volatility and Risk Institute

Hyeyoon Jung

Federal Reserve Bank of New York

Johannes Stroebel

New York University (NYU) - Leonard N. Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Xuran Zeng

New York University (NYU) - Leonard N. Stern School of Business

Yihao Zhao

New York University (NYU) - Leonard N. Stern School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2023

Abstract

We explore the design of climate stress tests to assess and manage macroprudential risks from climate change in the financial sector. We review the climate stress scenarios currently employed by regulators, highlighting the need to (i) consider many transition risks as dynamic policy choices; (ii) better understand and incorporate feedback loops between climate change and the economy; and (iii) further explore “compound risk” scenarios in which climate risks co-occur with other risks. We discuss how the process of mapping climate stress scenarios into financial firm outcomes can incorporate existing evidence on the effects of various climate-related risks on credit and market outcomes. We argue that more research is required to (i) identify channels through which plausible scenarios can lead to meaningful short-run impact on credit risks, given typical bank loan maturities; (ii) incorporate bank-lending responses to climate risks; (iii) assess the adequacy of climate risk pricing in financial markets; and (iv) better understand and incorporate the process of expectations formation around the realizations of climate risks. Finally, we discuss the relative advantages and disadvantages of using market-based climate stress tests that can be conducted using publicly available data to complement existing stress testing frameworks.

Keywords: climate risk, financial stability, systemic risk

JEL Classification: Q54, G1, G2

Suggested Citation

Acharya, Viral V. and Berner, Richard and Engle, Robert F. and Jung, Hyeyoon and Stroebel, Johannes and Zeng, Xuran and Zhao, Yihao, Climate Stress Testing (April 1, 2023). FRB of New York Staff Report No. 1059. Rev. June 2023, Available at SSRN: https://ssrn.com/abstract=4412022 or http://dx.doi.org/10.2139/ssrn.4412022

Viral V. Acharya

New York University (NYU) - New York University ( email )

Richard Berner

Leonard N. Stern School of Business, NYU ( email )

44 West 4th St
New York, NY 10012
United States

Robert F. Engle

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Volatility and Risk Institute ( email )

44 West 4th Street
New York, NY 10012
United States

Hyeyoon Jung (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Johannes Stroebel

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Xuran Zeng

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY NY 10012
United States

Yihao Zhao

New York University (NYU) - Leonard N. Stern School of Business ( email )

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