In speech, Fed governor says central bank will need to assess financial system for climate risk vulnerabilities

The financial system needs to be resilient to the effects of climate change, and the nation’s central bank will need to assess the system for vulnerabilities to important climate risks, a Federal Reserve Board governor said Friday.

In remarks at a San Francisco conference, Fed Gov. Lael Brainard said the central bank has important responsibilities for safeguarding the financial system’s safety in the face of negative shocks – including climate-related events (such as the series of wildfires over the past several weeks in California).

“Although there is substantial uncertainty surrounding how or when shifts in asset valuations might occur, we can begin to identify the factors that could propagate losses from natural disasters, energy disruptions, and sudden shifts in the value of climate-exposed properties,” Brainard told the “The Economics of Climate Change” research conference sponsored by the Federal Reserve Bank of San Francisco.

“As was the case with mortgages before the financial crisis, correlated risks from these kinds of trends could have an effect that reaches beyond individual banks and borrowers to the broader financial system and economy,” she said.

Brainard said that, for example, if prices of properties do not accurately reflect climate-related risks, a sudden correction could result in losses to financial institutions, which could in turn reduce lending in the economy. “The associated declines in wealth could amplify the effects on economic activity, which could have further knock-on effects on financial markets,” she said. “Beyond these physical risks, policymakers in some jurisdictions are assessing the resilience of the financial system to so-called transition risks: the risks associated with the transition to a policy framework that curtails emissions.”

The Fed governor argued that the private sector is already focused on climate risks. “Private-sector businesses – including insurance companies, ratings agencies, data companies, and actuaries – are actively working to understand climate-related risks and make this information accessible to investors, policymakers, and financial institutions,” she said.

Brainard said that the Carbon Disclosure Project (CDP), under the guidelines of the international Financial Stability Board (FSB) Task Force on Climate-Related Financial Disclosures (TCFD), estimates that the 500 largest companies by market capitalization are exposed to nearly $1 trillion in risk, half of which, she said, is expected to materialize in the next five years. “A majority of the reporting companies integrate climate risk into their business strategies and their broader risk-management frameworks,” she said.

Noting that the Fed expects banks to have systems in place to appropriately measure and respond to risks, Brainard said those risks may include severe weather events that can disrupt standard clearing and settlement activity and increase the demand for cash. “Banks also need to manage risks surrounding potential loan losses resulting from business interruptions and bankruptcies associated with natural disasters, including risks associated with loans to properties that are likely to become uninsurable or activities that are highly exposed to climate risks,” she said.

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