Working Paper: NBER ID: w31097
Authors: Viral V. Acharya; Richard Berner; Robert F. Engle III; Hyeyoon Jung; Johannes Stroebel; Xuran Zeng; Yihao Zhao
Abstract: We explore the design of climate stress tests to assess and manage macro-prudential 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 stress tests; macroprudential risks; financial stability; climate change; transition risks
JEL Codes: G00; Q00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| climate stress tests (Q54) | financial stability (G28) |
| climate stress scenarios (Q54) | credit risks (F34) |
| climate risk realizations (Q54) | bank profitability (G21) |
| deterioration in borrowers' repayment abilities (F65) | reduced future cash flows (G32) |
| adequacy of climate risk pricing (G19) | short-run asset revaluations (G31) |
| market-based climate stress tests (Q54) | traditional approaches (B52) |