DARK MODE
Jul 2021

IESE and CEPR Report: The Resilience of the Financial System to Natural Disasters

How resilient is the financial system to natural disasters? How can it strengthen its defenses? These questions underpin a comprehensive new IESE report, published by CEPR and supported by Citi, describing how central bank policy could be reimagined to tackle climate risks, examining the role asset managers have to play and suggesting how mitigation could be a potent form of preemptive damage limitation.
Citi Global Insights

The IESE report is timely given the vulnerabilities in the global financial system laid bare by Covid-19. As Andrew Pitt, global head of research at Citi, says, “The pandemic has brought pressing issues around the resilience of the global financial system to natural disasters into even sharper focus. Across the financial sector, we all have a part to play in ensuring that we are confronting the climate crisis with a united front and that policy responses and business practices are aligned.”

Xavier Vives, Chaired Professor of Economics and Finance at IESE Business School, says that banks have been part of the solution rather than the problem throughout the Covid-19 crisis, adding that the pandemic serves as a cautionary tale about the potentially devastating effects climate change could have on the financial system and the economy. “This is a call for action for central banks, regulators, financial intermediaries, asset managers, investors and society at large," he says.

Central Banks Take Centre Stage

For the lender of last resort, natural disasters—with their power to suddenly curb economic activity and destabilize financial markets—pose fundamental questions about their purpose. Natural disasters can trigger a sharp stock market correction, resulting in severe loss of wealth and soaring demand for liquidity. Any assessment of climate risk must factor in the impact of a warming planet on society. While central banks must include natural disaster risk in their prudential policy frameworks, excessive reliance on central bank backstops is potentially problematic. If participants expect a bailout, no matter what, they are more likely to indulge in riskier strategies.

One tool that could help is the implementation of climate stress tests to identify not only the size of climate risk exposures in the banking and insurance sectors but also the extent to which an orderly transition path, with early action, is feasible. Some central banks are already starting to introduce such tests. Once carbon emissions and carbon footprints are systematically reported at the firm level, the theory is that it will be much easier to monitor the year-by-year progress of companies in reducing their emissions and the progress being made by financial firms to decarbonize their portfolios.

More controversial is the question of whether climate change risk factors also touch on the conduct of monetary policy and the management of central bank reserves. These reserves are, by default, tilted towards assets from companies associated—directly or indirectly—with high carbon emissions. So in order for their policies to be effective, central banks need to ensure that their policies are aligned with the broader net-zero commitments of their countries.

Physical and Transition Risk Channels

Figure 2

 

 

 

 

 

 

 

 

 

 

Concerns persist about the ability of the financial sector to hedge long-term climate-related risks. The main challenge is that traditional models of asset pricing are not able to test whether climate risk is priced fairly. The fact that natural disasters are systemic in nature complicates hedging because of the lack of effective risk sharing.

First, as the report points out, significant estimation error can occur, as tail shocks are rare. Second, climate risk involves uncertainty given the long time horizon over which its effects are realized. And standard methods of risk management, such as diversification or hedging through derivatives, are not disaster proof. Some financial players are still focusing on short-term horizons simply because it is easier than grappling with the sophistication of predicting long-term effects.

Another weapon in the asset manager’s armory is corporate activism, through which asset managers can help drive political action. So far, one specific area in which activism has helped is in forcing disclosure of climate-related information. Environmental shareholder activism increases the voluntary disclosure of climate change risks, especially if initiated by institutional investors, particularly those with long-term holdings. Disclosure efforts have triggered a shift in voluntary disclosure by several, mainly public, companies. Questions remain about whether that disclosure matters to asset managers and if it results in a subsequent reduction in emissions.

The report’s authors say that it is important for asset managers to recognize that they can drive significant change, beyond their own operations, as long as they utilize that force in a constructive way.

Mitigation Is the Name of the Game

In the case of the global pandemic, a portfolio of textbook mitigation strategies—vaccines and non-pharmaceutical interventions—played a significant and under-appreciated role in stabilizing the financial system from the shock of Covid-19, the authors of the report argue. That stands in contrast to the central narrative that timely fiscal and monetary interventions alone safeguarded bank balance sheets and prevented a repeat of the 2008 global financial crisis.

Unlike Covid-19, damage from natural disasters affect not just labour but also capital. For example, extreme heat events affect labour productivity, while rising sea level and hurricanes threaten billions of dollars of both physical and housing capital. But just like with Covid-19, firms need to spend on a portfolio of decarbonisation measures in order to mitigate the effects of global warming.

The report—also featured in this column—concludes that sustainable finance mandates are still an order of magnitude too small or that the qualification criteria to be a ‘sustainable’ firm are not yet stringent enough. That said, evidence based on return differences for high- versus low-carbon emission companies over recent years suggests that the qualification criteria may be getting more stringent.

 

About the Report and Authors

Title: Resilience of the Financial System to Natural Disasters

By Patrick Bolton, Marcin Kacperczyk, Harrison Hong, and Xavier Vives

Conducted by the IESE Business School Banking Initiative, published by the Centre for Economic Policy Research and supported by Citi. The report is the third in the series of the Future of Banking, part of the Banking Initiative from the IESE Business School that was launched in October 2018.

Patrick Bolton is the Barbara and David Zalaznick Professor of Business at Columbia University and visiting Professor at Imperial College London.

Marcin Kacperczyk is Professor of Finance at Imperial College Business School.

Harrison Hong is the John R. Eckel Jr Professor of Economics at Columbia University.

Xavier Vives is Chaired Professor of Economics and Finance at IESE Business School.

 

Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research; however, it may contain thematic content previously expressed in an Independent Research report. For the full CGI disclosure, click here.

 

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