Working Paper: CEPR ID: DP17921
Authors: Henk Jan Reinders; Dirk Schoenmaker; Mathijs van Dijk
Abstract: We conceptually review Climate Risk Stress Testing (CRST) approaches to assess the impact of climate-related shocks on financial system stability. We distinguish between climate, economic, and financial modeling steps, and identify six types of climate shocks and four different approaches (macro-financial, micro-financial, non-structural, and disaster risk). Our review identifies several key limitations in current CRST approaches: (i) neglect of certain climate shock types (Green Swan and Minsky-type events); (ii) overreliance on macro models (with low sectoral and spatial granularity); (iii) incomplete modeling (lack of feedback effects); and (iv) limited scope (subset of causal channels and asset classes). We argue that these limitations may lead to significant underestimation of potential system-wide financial losses and offer suggestions for improving CRST approaches.
Keywords: climate stress test; integrated assessment model; Merton model
JEL Codes: E10; G13; G17; H23; Q54
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Climate shocks (Q54) | Banks' profitability (G21) |
| Climate shocks (Q54) | Banks' solvency (G21) |
| Climate shocks (Q54) | Banks' liquidity (G21) |
| Inadequate modeling (C52) | Underestimated financial losses (G41) |
| Neglected climate shocks (Q54) | Underestimated financial losses (G41) |
| Feedback loops (E32) | Amplified impacts of climate shocks (Q54) |
| Initial financial losses (G33) | Economic downturns (E32) |
| Economic downturns (E32) | Exacerbated climate risks (Q54) |