Keywords

5.1 Introduction

Financial stability can be defined as the condition in which the financial system, comprising financial intermediaries, markets and market infrastructures, is capable of withstanding shocks and the unravelling of financial imbalances (ECB 2019). In such a condition, the likelihood of disruptions in the financial intermediation process that are systemic and severe enough to trigger a material contraction of real economic activity can be considered to be mitigated. Already before the 2007–2009 Great Crisis, literature had highlighted three key characteristics that a financial system needs to have in order to maintain financial stability (e.g. Fell and Schinasi 2005). First, it has the capacity to efficiently and smoothly facilitate the intertemporal allocation of financial resources from savers to investors. Second, it can comfortably absorb both financial and real economic shocks. Third, it foresees mechanisms and practices to ensure that financial risks are assessed, priced and managed accurately by financial intermediaries. If one or more of these characteristics is not present, then it is likely that the financial system is moving in the direction of becoming less stable, and at some point in time it might exhibit instability. Monitoring and ensuring financial stability implies the throughout considerations of a full range of potentially harming factors, both external and internal to the financial intermediaries, including an assessment of the systemic relevance of the potential fragilities coming from each financial actor (this latter in particular to avoid contagion effectsFootnote 1).

When it comes to the possible impact of sustainability-related risks on financial stability, it is relevant to analyse the matter under the light of the possible emergence over time of new (and underestimated) financial risks. This chapter mainly focuses on this issue. To do that, it is structured as follows. First, it introduces the key features of the policy frameworks typically in place to ensure financial stability, as well the possible role of sustainability-related risks in these frameworks. This is done in Sects. 5.2 and 5.3. Second, it proposes a number of actions to be undertaken by policymakers to effectively shield financial stability from sustainability-related risks, with particular emphasis on the role of prudential supervisory authorities. This analysis is carried out in Sects. 5.4, 5.5 and 5.6. Finally, some preliminary conclusions on the relationship between sustainability-related risks and financial stability are presented in Sect. 5.7.

5.2 Brief Outline of the Policy Approach to Financial Stability

Given its broad scope, financial stability has been traditionally pursued by policymakers worldwide through a structured mix of regulation and organisational structures. To this extent, a preventive arm of policy action aiming at limiting situation of crisis is normally accompanied by a remedial harm dealing with specific cases of financial distress. The preventive arm typically includes the definition of prudential legislation, the empowerment of authorities and agencies with specific supervisory and regulatory competences, the public support to the establishment of a sound physical market infrastructure (and related market conventions), as well as the periodical provision of information by public authorities to the market on the most relevant economic and financial risks. On the other hand, the remedial arm usually foresees different forms of liquidity and solvency support for distressed financial entities as well as mechanisms to orderly managing deeper crises, including in case of entities’ resolution.Footnote 2,Footnote 3

Prudential supervision represents in such a context a central pillar for the safeguard of financial stability, and it is particularly relevant when it comes to the analysis of the systemic impacts of sustainability-related risks on financial risks. In broad terms, prudential supervision refers to the oversight of financial institutions to ensure that they are complying with relevant regulation and, more generally, are operating soundly and prudently in line with the principles laid down by the financial stability framework.

In the last two decades, it has been observed a tendency to assign prudential supervision of credit and insurance institutions to central banks, as a supplementary activity to the one of definition and implementation of the monetary policy.Footnote 4 A set of instruments is usually in the toolkit of prudential supervisory bodies to perform their tasks, with different instruments used for different purposes. As concerns the supervision of credit institutions, specific instruments are aimed at facing the cyclical systemic risks which may arise from the self-perpetuating interactions between lending, on the one hand, and the valuation of the real and financial assets used as collateral, on the other hand (the relationship between mortgages lending practices and the price of real estate is a typical example). Scenario analyses and stress testing are widely used techniques to monitor the potential magnitude of these types of risks. Other instruments look at the broad structure of the financial markets and are intended to attenuate the risks arising from the dominant positions that some institutions may acquire or can result from a high level of interdependence between financial institutions. The request of supplementary capital buffers for systemic relevant banks is a case of possible risk mitigating action in such cases (e.g. NBB 2018). Finally, other instruments exist dealing with specific risks. These are used in particular in the management of liquidity and capital positions in banking groups, or in the adjustment of the capital requirements in line with specific developments in the financial or property markets (e.g. NBB 2018).

5.3 Financial Intermediaries and Key Areas of Attention in the Management of Sustainability-Related Risks

In point of fact, an argument can be made according to the idea that the threat to financial stability coming directly from sustainability-related risks is somewhat limited in the short-term. The likelihood of the appearance of a systemic crisis in the financial sector in the next few years stemming from factors such as climate change, environmental degradation, social inequality or policy and technology shifts is reasonably low.Footnote 5 However, such a threat is expected to considerably increase in the future with the foreseen consolidation of sustainability-related risks, both in terms of frequency and magnitude (the severe consequences of the expected increase in temperature worldwide in the next decades are an example of this dynamicFootnote 6). For this reason, the implementation of forward-looking mitigation actions by both supervisory entities and financial institutions in order to preserve financial stability from sustainability-related risks should not be postponed too late in the future.

In this respect, at least two (interrelated) elements featuring the approach to risk-management and risk-taking of financial intermediaries should be carefully considered in the assessment of the possible impact of sustainability-related risks on financial stability. On the one side, the reliability of the existing risk-management frameworks, which may not systematically and coherently take into account the occurrence of sustainability-related risks and their link to financial risks. On the other side, the possible timing mismatch between the risk-taking strategies of financial intermediaries, often shaped to produce results in the short or medium term, and the profile over time of the sustainability-related risks, these latter expected to have increasingly disruptive effects in the longer term (e.g. BoE 2015; ACPR 2019; BIS 2020).

The need for financial intermediaries to adjust their risk management frameworks in order to consider the possible impact of sustainability-related risks on their financial risks may progressively become material. This implies the incremental development of specific risk management methodologiesFootnote 7 and, more in general, an enrichment of the risk culture. In particular, models able to predict the development of climate and environmental variables and simulate economic impact scenarios tailored on the business of each intermediary (specifically in terms of geographic areas and economic sectors served) would need to be progressively developed. In addition, as risk-taking activities are typically decentralised at operational units, the familiarity of all the relevant levels of the organisation with the possible consequences for the business of sustainability-related factors is also expected to play an increasingly important role.

On the other hand, it would be necessary for financial actors to critically reassess the reference horizon of their risk-taking strategies, in a way to be able to fully factoring in sustainability-related risks (e.g. BoE 2015). As a matter of fact, the tendency of part of the financial industry to privilege short-termism and strategies set to produce positive returns in the space of a few years clearly goes in the opposite direction of a throughout understanding of sustainability-related risks, which in many cases spread their effects in the long-term.Footnote 8 In this respect, it is important to underline that threats to financial stability may also arise from the possibility of disorderly adjustments of imbalances that have built up endogenously over a period of time because, for example, expectations of future returns were misperceived and therefore mispriced. This latter can be in particular the case for stranded assets and as a consequence of policy and technology changes.

5.4 The Wider Policy Approach

In general terms, two major areas of action can indeed be highlighted for policymakers in order to shield financial stability from the expected impact of sustainability-related risks. The first concerns the set of actions to put in place with the aim of limiting the foreseen incidence of these risks. The second refers to the most effective ways to effectively dealing with the effects of the risks.

The possibility of limiting the expected incidence of sustainability-related risks on financial risks does not lay only in the field of finance. On the contrary, it implies the prior assessment of the different facets of the sustainability of human activities on the planet as well as the conception and evaluation of the possible corrective measures. As a matter of fact, the possibility to trigger a trend reversal in matters such as climate change or environmental degradation depends on a multitude of factors. It can be expected that aspects regarding political engagement, effective regulation, technological improvements, scientific research and investment flows will jointly determine the feasibility and speed of the changeover (e.g. EC 2019b; Migliorelli and Dessertine 2019). For this reason, actions aiming at reducing the sustainability-related risks should indeed be nested in the wider policy initiatives having as objective the fight against climate change, the restoration and preservation of the environment, the reduction of the inequalities. On the other hand, it can be argued that policy actions aimed at specifically dealing with the financial risks stemming from sustainability-related risks (that is understanding, measuring and managing the relationship between the different types of sustainability-related risks and financial risks) can be more easily narrowed in scope, and specifically assessed in the traditional perimeter of action of prudential supervision authorities.

In such a context, Table 5.1 reports six key policy actions that jointly would likely allow to effectively limit and deal with the sustainability-related risks and, in turn, would also safeguard financial stability. In point of fact, adopting such a set of actions would results first and foremost in the definition of a comprehensive policy programme backed by a strong commitment towards the achievement of a sustainable society.

Table 5.1 Key policy actions to safeguard financial stability from sustainability-related risks
Full size table

5.4.1 Implementing the Paris Agreement and reaching the Sustainable Development Goals

The Paris Agreement and the Sustainable Development Goals, both dated 2015, are today the cornerstones of the international community’s engagement towards the fight against the climate change and the construction of a more sustainable and fair society. However, it is increasingly evident that the fortune of these deals will decisively depend on the level of political commitment during the (necessary long) implementation phase.Footnote 9 Some jurisdictions, such as the European Union, have already made some concrete steps to drive the change,Footnote 10 while in other cases, as for the United States, a certain level of disengagement has been observed.Footnote 11 Intermittent political commitment can risk to dilute the efforts and the results reached thus far. On the contrary, a full implementation of the Paris Agreement and the achievement of the Sustainable Development Goals will allow a sensitive reduction of all the sustainability-related risks, in this way also reducing their potential impact on financial stability.

5.4.2 Mainstreaming Sustainable and Green Finance

Sustainable finance may be referred to the process of taking due account of environmental and social considerations in investment decision-making, leading to increased investments in longer term and sustainable activities (EC 2018b).Footnote 12 In this respect, green finance can be considered to be part of the wider sustainable finance landscape.Footnote 13 The growth of sustainable finance market, and in particular of green finance, can be considered today robust, as increasing volumes are accompanied by sectorial diversification and a continuously widening range of products. Nevertheless, it can be argued that the actual levels of issuance of sustainable securities is still nothing more than “a drop in the ocean” when it is compared to estimated needs for an effective financing of the sustainability objectives.Footnote 14 As a matter of fact, for sustainable finance to effectively contribute to mitigate the sustainability-related risks, from a promising niche it has to evolve in a mainstream way of financing. To do that, the full involvement of key policymakers is fundamental as market forces alone will most probably be ineffective to produce the necessary transition.Footnote 15

5.4.3 Assessing the Impact of Climate Policies in Order to Limit Side Effects

Climate policies in particular are expected to trigger an unprecedented shift in the structure of the economies that will embrace the change. If effective, these policies will be also accompanied by a new stream of technology advances that will help reducing greenhouse gas emission and eventually minimise the dependency from fossil fuels. Policy and technology shifts may however produce considerable side effects as they can result in a rapid and unaffordable obsolescence of a large amount of economic assets.Footnote 16 A typical case could be represented by the loss of value of oil companies in a society with 100% of electric cars and green buildings. As a matter of fact, financial stability could also be threatened by policies aiming at fostering sustainability without considering the consequent impact on traditional sectors and disrupted incumbent industries. Hence, it is necessary for climate policies to be backed by an assessment of potentially negative impacts on specific economic actors, and foresee when necessary adapted mitigating and transition measures (e.g. in the form of “transition funds”).

5.4.4 Fostering Economic Resilience to Sustainability-Related Risks

Financial stability may increasingly depend on the economic resilience to sustainability-related risks of the different economic actors. In this respect, the strengthening of the response capabilities to climate and environmental risks in particular (which can eventually translate into physical risks and other risks arising from natural catastrophes) should be considered a key policy objective in the years to come. In principle, such resilience should be endogenously built over time by economic actors, in particular by continuing assessing the potential impacts of sustainability-related risks on their businesses, and planning investments consequently. Nonetheless, the role of public actors in this area is still of the utmost relevance and should consist in at least three concrete actions. First, to raise awareness towards relevant stakeholders on the expected increasing incidence of sustainability-related risks on their business, that can be underestimated due to short-seeing approaches to risk-taking and focus on the specific phase of the business cycle. Second, to ensure that key national and international infrastructures are resilient to sustainability-related risks (and in particular to the ones linked to climate change), in order to avoid major disruptions in trade and business operations. Third, to foster market discipline and allow better pricing and monitoring of the exposure of businesses to sustainability-related risks, in particular by identifying and set specific disclosure requirements for these risks.Footnote 17

5.4.5 Ensuring Prudential Supervision of the Impact of All Sustainability-Related Risks on Financial Markets

As of today, only a few authorities in charge of financial stability have started to study the possible incidence of sustainability-related risks on financial risks, by focusing on climate change-relate risks and, at a lesser extent, to environmental-related risks (e.g. PRA 2018; ACPR 2019). As the potential impact of sustainability-related risks become more accepted and material, the need for a more structured approach under a prudential supervision perspective also materialises. Among the suitable actions, systematically monitoring the overall exposure and resilience of the financial system to sustainability-related risks and encouraging financial intermediaries to develop specific methodologies for handling such risks conveys particular importance. In addition, an assessment of the existing prudential requirements can also be needed. In fact, it can be argued that existing capital requirements may largely play against the full inclusion of sustainability-related risks in risk management frameworks and increase the possibility of market failures. As the Basel framework adopt a risk-weighted approach to capital consistencies, banks may need to bear increasing capital costs when fully considering sustainability-related risks. Hence, an effort to better integrate such risks into prudential supervision frameworks by verifying the suitability of the existing capital requirements may be also necessary in the mid-term.Footnote 18

5.4.6 Establishing Global Governance Structures for the Analysis of the Impact of Sustainability-Related Risks on Financial Markets

The establishment of global structures for the fair assessment of the possible impacts of sustainability-related risks on financial markets can produce considerable benefits when it comes to the need to identify the most effective ways forward to deal with these risks. In point of fact, sustainability-related risks are often originated from the cumulative behavior of actors located in several different countries or even continents. In addition, the response to the threats coming from sustainability-related factors may not be effective if not implemented globally (the fight against the increase of temperatures due to global greenhouse gas emissions is a typical example). A global governance for the sustainability-related risks implies the creation of specific bodies or agencies empowered to discuss relevant items (such as regulation effectiveness, data gathering and sharing, methodological approaches, standards for disclosure) and formulate policy recommendations. The Network for Greening the Financial System (NGFS),Footnote 19 the Sustainability Accounting Standard Board (SASB) Footnote 20 and the Task Force on Climate-related Financial Disclosures (TCFD) Footnote 21 represent noteworthy initiatives in this direction, even if limited in scope.

5.5 Sustainability-Related Risks and Prudential Supervision

In the last a few years only, first progress has been made by financial stability authorities in understanding how the financial system may be vulnerable to the physical risk of climate change and to risks from a slow response to the need for a transition to an economy with lower carbon emissions (ECB 2019). However, these authorities, which include in particular central banks, still face significant gaps in the availability of assessments of risk management and stress testing frameworks, as well as in the availability of comprehensive and reliable disclosures and the reporting of relevant data, such as carbon emission-related data (ECB 2019; BIS 2020).

As mentioned above, prudential supervision practices should evolve in order to take into account the novelties introduced by sustainability-related risks.Footnote 22 In this respect, the NGFS provided in 2019 a high-level roadmap for the integration of climate-related factors into prudential supervision, highlighting a possible course of action. The actions suggested refer to raising awareness and building capacity among firms, assessing climate-related risks, setting supervisory expectations, requiring transparency to promote market discipline, mitigating risk through financial resources. The full roadmap and related measures is reported in Table 5.2.Footnote 23

Table 5.2 High-level roadmap for the integration of climate-related factors into prudential supervision
Full size table

Such a comprehensive approach has indeed the merit to fully consider climate-related risks as elements having an impact on financial risks, and to propose a way forward to gradually put in place a structured prudential supervisory framework to the management of these risks. However, the NGFS’s recommendations are not compulsory and the reach of this body is indeed not global (in particular, the United States have not taken part to this initiative). Hence, a certain level of heterogeneity in the responses to this call for action should be expected. In addition, the limitation to climate-related factors (that is, not including among others environmental, social, policy and technology factors) still makes the full management of the impact of sustainability-related risks on financial risks an objective far to be reached. In this respect, the gradual extension of prudential supervisory action to other sustainability-related risks should be encouraged.

5.6 A New Role for Central Banks?

Central banks, in particular in Europe, are gradually emerging as critical actors in the policy action aiming at dealing with the potential financial risks coming from climate change (e.g. BoE 2015; PRA 2018; ACPR 2019), in this way paving the way for a better comprehension of the sustainability-financial risk nexus. Such dynamism has been linked to their prudential supervision mandate and it mainly results in assessing climate risks as a new source of financial risk potentially able to harm financial stability. In this vein, in the most ambitious approaches, the possibility to run “climate change stress tests” is under discussion in order to measure the resilience of financial intermediaries to different climate scenarios.

Nevertheless, when considering the possible role of central banks in ensuring that financial stability is not affected by sustainability-related risks, an additional dimension of action might be discussed. This refers to the possible extension of the central bank’s mandate to formally include the support to the attainment of the sustainability objectives. Such an option presents considerable potential benefits, but also engenders some concrete risks. In practice, this would probably mean to integrate sustainability considerations in the implementation of the monetary policy, by setting specific eligibility criteria for the securities object of the central bank’s open market operations of assets purchase or for the banks’ marginal deposit operations towards the central bank. Part of the central banks’ operations (in terms of a fixed portion, a ceiling or a floor) might hence be reserved to sustainable securities. In this respect, the eligibility criteria to be fixed would eventually need to mirror industry standards as concerns the labelling of sustainable or green securities and consider, when present, existing policy actions aiming at strengthening sustainable finance.Footnote 24 The main benefit of such an approach would be a strong contribution to mainstreaming sustainable finance, by directing an unprecedented amount of financial resources towards specific sectors or activities (the ones considered to foster a more sustainable economy). Eventually, this will also reduce the incidence of sustainability-related risks and in turn would also shield financial sustainability. Nevertheless, some concrete risks can arise from such an approach. On the one side, underfunding dynamics and higher costs of financing could hit sectors not considered as being sustainable, again potentially triggering wide reductions in related assets values. On the other side, and maybe even more importantly, a further widening of the mandate of central banks beyond the traditional primary objective of maintaining price stability might result in a situation in which the effectiveness of the monetary policy could be diluted or even endangered.Footnote 25 For this reason, a throughout prior assessment of the policy and governance implications of such an extension of scope would be necessary.

5.7 Sustainability-Related Risks and Financial Stability: Summary and Preliminary Conclusions

As of today, existing evidence is not sufficient to state strong conclusions on the specific impact of sustainability-related risks on financial stability. Nevertheless, first warnings from international and national institutions have already been launched (e.g. BoE 2015; BIS 2020). Realistically, little probability exists that factors such as climate change, environmental degradation, social inequality, policy and technology shifts will cause in the near term a systemic-wise crisis in the financial system. This notwithstanding, such a possibility is expected to become more concrete in the longer term, in particular if the observed trends linked to climate change and environmental degradation will keep consolidating. In this respect, the harm for financial stability can principally derive from a generalised misinterpretation by financial intermediaries of the magnitude of the challenge ahead. For this reason, understanding the direct and indirect consequences of these new sources of risk on their businesses is an essential preliminary condition to safeguard financial stability. Such an awareness would need to be reflected in the evolution of existing risk-management frameworks and in a recalibration of risk-taking strategies in order to consider the profile over time of sustainability-related risks. On the other side, policymakers are also expected (and in some case have started) to act. In particular, a refinement of the prudential supervisory approaches, by also including instruments able to take into account the features of the different types of sustainability-related risks, is today necessary. Such intervention would be more effective if complementary to wider policy actions to be carried over out in the frameworks given by the Paris Agreement and the implementation of the Sustainable Development Goals (which, as a by-product, would also allow to reduce the incidence of the sustainability-related risks on the financial risks). In such a context, central banks could assume an unprecedented leading role, as major actors in the supervision of the financial system and potentially able to help mainstreaming sustainable finance. In particular, the integration of sustainability considerations in the execution of the monetary policy would drastically increase the flow of resources directed to finance sustainable activities. However, such possible a new role could carry some relevant drawbacks. This would be principally linked to the need for central banks to consider and integrate a wider policy context and to the possibility to dilute the effectiveness of the monetary policy action in pursuing the primary objective of preserving price stability.