New report: Improving the resilience of the financial system in response to Natural Disasters

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  • The 3rd Future of Banking report by IESE and CEPR explores how prepared the financial system is for future pandemics and climate change

The Covid-19 pandemic has exposed severe vulnerabilities in the global financial system, and serves as a cautionary tale for the potentially devastating effects that future natural disasters and climate change could cause to the world economy. The question of whether society is adequately prepared and what measures can be put in place to mitigate these risks has never been more pertinent.

A new CEPR/IESE report by Patrick Bolton, Marcin Kacperczyk, Harrison Hong, and Xavier Vives tests precisely how resilient the financial system is to natural disasters and discusses what can be done to make it more resilient. The report details how to reshape central bank policies to address climate-related risks, debates the role of asset managers in dealing with natural disasters and climate risk, and explains why mitigation is a form of self-insurance to limit the systemic risks of global warming.

This is the third report in the series on The Future of Banking, part of the Banking Initiative from the IESE Business School and supported by Citi. In the report, the authors stress the need for the financial sector – from asset managers, supervisory regulators to central banks – to play a major role in the prevention and taming of these disruptive, environment-related events. To do so, climate risk drivers and their transmission channels must be accurately addressed, precise measurement of the economic and financial impact of the different risks is essential, and mitigation and risk-reduction measures must be adequately developed. Policymakers thus have a responsibility to guarantee the stability of the financial system and use the fiscal and environmental instruments at their disposal. Climate risk should not be measured through short-term horizons and there must be an internationally coordinated response to a global issue. 

“The Covid-19 crisis and the subsequent downturn have reinforced the need to evaluate and address highly disruptive environment-related events as well as the strategic importance of sustainable finance in the upcoming years”

The risks involving natural disasters and climate change are large and complex. As a result, they require a broad range of players and tools to manage them. Fighting climate change will require a combination of public intervention and private sector mitigation strategies to price and hedge the long-term implications of climate-related events. Carbon abatement proposals should include net-zero commitments made by governments and companies worldwide to decarbonise the economy, and sustainable finance mandates should be introduced, backed by financial intermediaries to incentivise firm efforts towards decarbonisation.

Three key messages emerge from the report:

  • Central banks must play a proactive role in promoting mitigation policies and coordinating climate risk policies consistent with government mandates, the private sector and civil society. Central banks should focus on the development of forward-looking scenarios and the implementation of climate stress tests. Central banks must include natural disaster risk in their prudential policy frameworks. The policy response to stabilize the financial system, however, should avoid an excessive reliance on central bank backstops – ‘lender of last resort’ interventions should not become the default.
  • Asset managers can facilitate the management of climate risk and promote green financing through hedging and engagement in mitigation. Although an array of hedging instruments have been developed by the financial industry in response to crises, the systemic nature of natural disasters complicates the hedging activity for financial players because of the lack of effective risk-sharing. Financial markets and asset managers could discipline market participants to stimulate mitigation efforts by the real sector.
  • Climate mitigation investments, such as incentives for firms to adopt decarbonisation technologies and reach net-zero targets, could have similar positive effects on stock valuations and for climate risk-management responses to those seen with the rapid development of vaccines to combat the pandemic, which played a significant role in stabilizing the financial system during the Covid-19 shock. Clear clarification of financial commitments and enforcement of stringent standards to combat climate change is essential in this regard.

The report shows that climate change and associated natural disasters will undoubtedly cause severe disruption to the global financial system without the implementation of adequate prevention and mitigation strategies. The Covid-19 pandemic should serve as a stark warning that the financial sector, from firms to central banks, must act now to ensure future stability.