A macroprudential approach to compound climate risks

Climate-related shocks will not occur in isolation. Instead, they will unfold within an existing macro-financial environment, where their interaction may lead to compound losses. In such an environment, macroprudential buffers earmarked for specific risks have limitations, as they might not account for important correlations between climate-related shocks and other sources of financial vulnerability, nor for the extent to which climate-related shocks might compound existing challenges in the real economy and financial sector. In light of such complex challenges, this report investigates how a holistic approach can enhance the financial system’s ability to absorb compound shocks.

By exploring theoretical frameworks and practical approaches, the authors make the case for a consolidated macroprudential buffer framework to ensure the financial system’s resilience under increasingly complex and uncertain conditions.

Recommendations

Macroprudential authorities can make an integral contribution to a more resilient financial system capable of withstanding the evolving challenges posed by climate change, economic shocks and their complex interplay. The authors recommend that macroprudential policymakers:

• Adopt a holistic approach to macroprudential buffer setting, which captures interactions between novel sources of systemic risk, such as climate-related risks, and more established sources of systemic risk, such as macro-financial conditions.
• Be mindful of the limits of earmarked buffers in the context of compound risks. The policy response to mitigate these limits could lie on a continuum between a maximalist approach (consolidated buffers addressing multiple sources of prospective compounding systemic risk) and a more minimalist approach (holistic systemic risk assessments accounting for prospective compound risks that serve as a complementary cross-check for existing earmarked buffers).

While also recognising the uncertainty associated with assessing compound risks and implementing macroprudential capital buffers, the authors recommend the following practical ways to calibrate macroprudential buffers:

• Leveraging the methodologies developed by supervisors to address uncertainty, including in the context of climate-related risks. This way, policymakers can better prepare for the unpredictable and often unprecedented nature of compound risks with advanced scenario analysis, stochastic scenario modelling and probabilistic approaches. They can also overcome potential inaction biases by prioritising collective action, while strengthening resilience through transition planning mechanisms and forward-looking strategies.
• Adopting an adaptive and forward-looking approach to macroprudential policy implementation. A dynamic, forward-looking calibration of buffers can better reflect the evolving landscapes of risks and the development of knowledge about them. A progressive deployment of measures, factoring in learning that accompanies implementation, could help macroprudential authorities fine-tune buffer calibration.