Models used by some of the largest global financial institutions to measure the vulnerability of their balance sheets to climate risks, including physical risks, are not up to the task of quantifying the larger threat to the global financial system, according to a new report from researchers at the Federal Reserve Bank of New York earlier this month.
“We find that most models in the existing literature focus on estimating the extent of economic harm and have yet to reach the stage where they can reliably assess risks to financial stability,” the researchers said. “We conclude that assessments based on the existing literature are subject to a high degree of uncertainty, limiting their potential role in policymaking.”
A particularly concerning issue is the impact on asset valuations. When climate-related physical risks are not properly priced into real estate or other assets, sudden realizations of risk can cause drastic price adjustments, leading to significant market disruptions.
The report points out that extreme weather events, like hurricanes or wildfires, can result in significant damage to property and infrastructure, thereby diminishing asset values and creating ripple effects across the larger financial system. A large-scale hurricane impacting coastal real estate markets could lead to a surge in mortgage defaults, reducing liquidity for lenders and causing losses in mortgage-backed securities.
Similarly, wildfires in California or floods in the Midwest could disrupt local economies, result in corporate defaults, and create stress on regional banks.
Moreover, the report highlights the increasing frequency of climate events that could occur simultaneously across different regions, referred to as "correlated risks." A single financial institution exposed to multiple regions affected by simultaneous climate events might face compounded losses, increasing the likelihood of a systemic financial crisis.
The report also notes that these models have limitations, particularly when it comes to accounting for long-term climate changes and uncertainties. The authors call for future research to develop more comprehensive models that integrate different methodologies to create a holistic view of how physical risks could impact financial stability over time.
“Our review of modeling assumptions and results shows that currently available insights should be interpreted with caution, since the literature remains relatively thin,” the report states.
The Fed research suggests that general equilibrium models, dynamic stochastic general equilibrium models, and agent-based models are particularly promising for capturing the complexity of climate-related financial risks.
“A key message of this article is that we are closer to the beginning than to the end of integrating climate-related risks and financial system vulnerabilities into modeling frameworks,” the researchers say.