Building on the FSB Stocktake of financial authorities’ experience in including physical and transition climate risks as part of their financial stability monitoring, this report assesses the channels through which physical and transition risks could impact the financial system and how they might interact. Particular focus is on the potential amplification mechanisms and cross-border effects, and on the channels that could materialise in the short-to-medium term.
Current central estimates of the impact of physical risks on asset prices appear relatively contained but may be subject to considerable tail risk. The manifestation of physical risks could lead to a sharp fall in asset prices and increase in uncertainty. A disorderly transition to a low carbon economy could also have a destabilising effect on the financial system.
Climate-related risks – physical and transition risks – may also affect how the global financial system responds to shocks. They may give rise to abrupt increases in risk premia across a wide range of assets. This could alter asset price (co-)movement across sectors and jurisdictions; amplify credit, liquidity and counterparty risks; and challenge financial risk management in ways that are hard to predict. Such changes may weaken the effectiveness of some current approaches to risk diversification and management. This may in turn affect financial system resilience and lead to a self-reinforcing reduction in bank lending and insurance provision.
There are various actions that financial institutions can take – and are taking – to reduce or manage their exposure to climate-related risks. However, the efficacy of such actions taken by financial firms may also be hampered by a lack of data with which to assess clients’ exposures to climate-related risks, or the magnitude of climate-related effects. Robust risk management might be supported by initiatives to enhance information with which to assess climate-related risk.
The FSB will conduct further work to assess the availability of data through which climate-related risks to financial stability could be monitored, as well as any data gaps.