Towards a post-pandemic policy framework to manage climate-related financial risks and resilience

ABSTRACT

All G20 countries have adopted policies to tame financial instability in response to the COVID-19 pandemic. Post-pandemic financial measures are designed to support bank lending, boost financial markets’ liquidity, reduce banks’ funding liquidity costs, and allow for a smoother transition in monetary and fiscal policies. However, when analyzed in a broader framework that considers possible interlinkages between the pandemic and threats posed by climate change, these measures are not aligned with the goals of the Paris Agreement. Indeed, there is no evidence that recovery policies to date reflect sustainability priorities nor do they account for climate-related financial risks. The analysis carried out suggests that this failure to account for climate change could amplify the build-up of additional climate-related financial risks and of existing vulnerabilities in the financial system, leading to increased overall exposure to climate risks and thus undermining the low-carbon transition in G20 countries. Against this backdrop, the paper reviews several financial measures to avoid increasing the high carbon bias of existing policies and to explicitly address climate-related risks in the financial sector. The author proposes an enhanced macro-prudential policy framework to achieve three interrelated objectives: tackle climate-related financial risks, scale up green finance for a greener and more sustainable recovery, and preserve the global financial system’s resilience.

Key policy insights

• A macro-prudential strategy aligned with the goals of the Paris Agreement is needed to address carbon bias, avoid the increase of climate-related financial risks, and reorient financial flows towards sustainable investments.

• ‘Green-enhanced’ capital requirements can be used, but they need careful calibration to prevent financial instabilities, while green liquidity instruments pose fewer implementation concerns.

• Climate-related large exposure limits could help contain systemic risks deriving from the materialization of climate risks.

• Harmonized taxonomy and enhanced climate-related disclosure requirements are critical for the correct functioning of proposed climate-related financial instruments.

• Implementing such instruments in a post-pandemic financial policy framework could help underpin a transformative financial response to climate change while strengthening the resilience of the global financial system.

KEYWORDS:

• COVID-19
• Green recovery
• climate-related financial risks
• financial stability
• financial resilience
• Paris Agreement
• climate change

Acknowledgements

The author would like to thank three anonymous referees and the journal’s editor, Dr. Corfee-Morlot for valuable comments which helped to improve the quality of the paper substantially. The usual disclaimer applies.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 For further details, see Appendix A.1.

2 Green finance has received particular attention in the past years for its role in catalyzing the transition towards sustainability (Falcone, 2020). Recently, Mark Carney’s commitment as UN Special Envoy for Climate Action has sparked a renewed interest in this topic. In his last public statements, he argued that achieving climate goals will require all forms of finance and that coordinated action is needed to ensure that the financial sector can allocate capital to manage risks and seize opportunities in the transition to net-zero (Carney, 2021a, 2021b).

3 To qualify as HQLA, according to the Basel Committee on Banking Supervision, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible. For additional insights, see BCBS, 2019.

4 Liquidity risk is the risk that a solvent bank is unable to meet its cash flow needs using its own stock of liquidity and borrowed funds without materially affecting its daily operations or overall financial condition.