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Assessing the risk of climate change by means of stress tests financial

Tobias Adrian, James Morsink, and Liliana Schumacher

on February 5, 2020

While the company is preparing for the chaos that could result from climate change, it is essential to assess the magnitude of shocks that the economy could soon suffer. One of the ways to quantify the effects of the shock wave, potentially systemic, which could flood the financial system is to conduct ” stress tests “, an analytical procedure well designed as the IMF, the world Bank and the financial controllers have been using for decades to plan for scenarios in detail in order to prevent future financial crises.

Measure the risks

A new study of the services of the IMF [insert link] shows the tests of financial resilience as an innovative tool to be invaluable. The tests of resistance to climate assess the potential effects of a climate crisis on the financial system, both globally and domestically.

The stress tests reflect the manner in which a financial shock, such as an economic downturn suddenly or a collapse of real estate prices, which can be amplified through the financial system. They examine in particular the links between the financial institutions and the daily functioning of the economy, between the problems of solvency and liquidity, and between States and financial institutions.

For a long time, the stress tests manage to answer the question of whether financial institutions such as banks and insurance companies will be able, even in the worst-case scenarios, to provide all the financial services major. Add climate change factors to the current methodology of stress tests would help public authorities and business leaders to prepare for the wide range of financial shocks that could lead to climate hazards.

Constantly adapt to

To maintain their effectiveness, the tests of resistance must adapt to new risks. Initially, they studied the resilience of financial institutions, taken separately. The global financial crisis of 2007-2009 has raised interest in the methodologies of stress tests designed to quantify the risks to the financial system as a whole (tests of resistance, ” macro-prudential “). Over the years, the IMF has improved its analytical tools-financial and observation of scenarios, thus extending the scope of tests of resistance to a wider range of threats.

The physical risks arising from the destruction of property, and the risk of transition related to changes in public policies and technologies that affect the global transition to a low-carbon economy become an integral part of the stress tests of the IMF. The resistance tests of the newly redesigned can assess the potential impact of these risks on the financial stability and economic growth.

Some tests of the resistance of the IMF have already been conducted on the physical risks related to natural disasters, in particular for small island States like the Bahamas, Jamaica and the islands of Samoa. Natural disasters have been used as the shock-triggering adverse scenarios (for example, a powerful hurricane that causes losses of property and overnight in tourist activity). Among the direct losses include the destruction or diminution of value of the goods and guarantees, which in turn affects the value of the exposure of financial institutions to businesses and households. In some countries, the total economic loss exceeds 200 % of the national GDP. This is the case of Dominica, which was struck by hurricane Maria in 2017. Now, the tests of resistance to physical hazards will make more account of the effects of macro-natural disasters more frequent and larger.

The tests of resistance to the transition towards a low-carbon economy is a new practice that is evolving quickly. Of shocks related to the transition will probably occur, because the global economy away from industries dependent on non-renewable resources, such as coal. The financial institutions could suffer losses as a result of their exposure to companies whose business model is not based on the green economy. These enterprises might be faced with a decline of profits, business disruption and increased cost of financing resulting from public policies, technological developments and a change in the behaviour of consumers and investors. The risk may materialise, in particular if the transition to a low-carbon economy is a sudden (due to an inertia prior), poorly conceived, or non-co-ordinated on a global scale. One of the crucial next steps of the design of the stress tests on the risks of transition will be to highlight the indirect effects or “second generation” : when a decrease in the market price of assets leads to bradages which further reduces the price of the securities, resulting in a vicious circle, and a mechanism of amplification of a shock earlier.

To include climatic factors in the stress tests will help the government, business leaders and investors to take into account climate threats. It is as well as the IMF and the world Bank will be able to inform those responsible for a diverse range of institutions (central banks, control agencies, think tanks and academics) to help the company prepare for emergencies that require rapid response and agile.

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Tobias Adrian is a financial advisor and director of the department of monetary and capital markets IMF. In this capacity, he leads the IMF’s work on financial sector supervision, monetary policy and macroprudential, financial regulation, debt management and the capital markets. In addition, he oversees the capacity-building activities in the member countries of the IMF. Before joining the IMF, Mr. Adrian was a senior vice-president of the federal reserve Bank of New York and deputy director of the Research and Statistics Group.

Adrian has taught at Princeton university and New York university and is the author of numerous publications in economic journals and financial, including the American Economic Review, the Journal of Finance, Journal of Financial Economics and the Review of Financial Studies. Mr. Adrian holds a phd from the Massachusetts Institute of Technology, a master’s degree from the London School of Economics, a diploma of the Goethe-university of Frankfurt and a master’s degree from the university of Paris-Dauphine. He obtained his diploma of end of secondary studies in literature and mathematics at the Humboldtschule Bad Homburg.

James Morsink is deputy director of the department of monetary and capital markets, in charge of the assessments of the financial sector, as well as the management of the strategy and resources of the department. Previously, he was responsible for bilateral surveillance (and the assessments of the financial sector).

For more than 26 years, his work at the IMF focuses on the macroeconomic issues and macrofinancial the world. During the 90s, he worked on the transition to a market economy in Mongolia, the financial crisis in Thailand and the banking difficulties in Japan. During the first decade of the 2000s, it has been one of the leaders of the preparation of the Outlook for the global economy, leading missions in the United Kingdom and Ireland, and negotiated the agreement with Hungary, as well as the flexible credit line to Poland. He joined the department of monetary and capital markets in 2012 as head of the policy unit. Then, he was chief of mission of the assessment program of the financial sector in 2014. He became deputy director in 2015. He holds a ba from the university of Princeton and a doctorate from the Massachusetts Institute of Technology.

Liliana Schumacher is a senior economist at the IMF. She is the author of numerous publications on topics related to financial stability, the bank runs, the results of the banks and the stress tests. His research has been published in working papers of the IMF and in economic journals and financial peer-reviewed. She has led the program the financial sector assessment (FSAP) in Guatemala, Paraguay, Kosovo and Armenia. She has also worked as head assistant of the missions FSAP Singapore, Sweden, Spain and Latvia. In addition, she has taken stress tests in the context of many of the FSAP. Before joining the IMF, she was an assistant professor of international business at the George Washington university. She holds a phd in economics from the university of Chicago.

EDITOR’S NOTE: This article is a translation. Apologies should the grammar and/or sentence structure is not be perfect.

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