A new study published on the prestigious journal Nature Climate Change highlights how climate-related damages impact on the stability of the global banking system. Climate change will increase the frequency of banking crises while rescuing insolvent banks will cause an additional fiscal burden and an increase of public debt to GDP by a factor of 2. The paper has been co-authored by an international team of researchers from the CMCC Foundation, RFF-CMCC European Institute on Economics and the Environment (EIEE), Scuola Superiore Sant’Anna, Bocconi University and Politecnico di Milano (Italy).

A new line of research started to study the impacts of climate change on the financial system. Financial crises entail costs both to the economy, because of contractions in demand and production, and to public finances (fiscal costs), due to the rescuing interventions of the governments.

Climate change and climate-related extreme events, such as floods, landslides or storm surges, would increase the infrastructures at risk and adversely affect insurance companies, thus raising premiums. Moreover, increased temperatures affect labour productivity and the profitability of firms. The deterioration of the balance sheets of affected firms and consumers might induce losses in the lender banks. Specifically, the inability to repay obligations – because of insolvency – generates what are usually referred to as non-performing loans (or bad debt) in the balance sheet of banks and other financial institutions, with possible systemic implications such as those experienced on a global scale during the 2008 financial crisis, imposing costs to the governments for rescuing interventions.

This new study, published on the prestigious journal Nature Climate Change, contributes to the debate by analyzing the impacts of climate change on the stability of the global banking system while quantifying banking crises and the public costs of bailing out insolvent banks.

The results underline how climate change might affect even an apparently less exposed sector such as finance. More in detail, the climate-induced instability of the financial system might significantly increase, thus amplifying the impacts of climate change on economic growth.

The study is the first to examine this effect: the outcomes of the analysis suggest that climate change will increase the frequency of banking crises (from +26% up to 148%) while rescuing insolvent banks will cause an additional fiscal burden of approximately 5% to 15% of GDP per year and an increase of public debt to GDP by a factor of 2 in the year 2100.

According to the study’s lead-author, Francesco Lamperti, assistant professor at Scuola Superiore Sant’Anna in Pisa and junior scientist at the RFF-CMCC European Institute on Economics and the Environment, “the idea behind our research was to understand how the impacts of climate change will affect the global banking system. Actually, the impacts concern firms because climate change affects and reduces the productivity of labour and the stock and quality of capital. However, cascades of firms’ bankruptcies induced by climate damages might affect the financial system. In particular, we sought to understand how the global banking system could be challenged by firms’ insolvency, quantifying banking crises and the public costs of bailing out insolvent banks. On the one hand, we wanted to investigate the stability of the financial system, on the other, we wanted to assess the contribution of climate-induced financial distress to such a shrinkage of economic performances due to the deterioration of the banks’ balance sheets induced by climate change. We know in fact that crises in the banking system exacerbate the downturns in the real sector through credit crunches, that is, periods of substantially reduced credit inflow blocking the investments of firms. This in turn may further reduce the economic growth”.

The study used an agent-based model to simulate the behaviour of an economic system comprising heterogeneous households, energy plants, banks, policy makers and firms exposed to climate damages. The model, which was calibrated on stylized facts, reproduces economic growth and emissions consistent with the Shared Socio-economic Pathways (SSP5 as central case). As the magnitude of future emissions and climate change impacts is uncertain, researchers examined different emission scenarios and different kind of impacts in order to show how their results were robust under these different assumptions.

“The main result”, explains Massimo Tavoni, director of RFF-CMCC European Institute on Economics and the Environment and professor at Politecnico di Milano, “is that climate damages significantly reverberate to the financial system: our results clearly show that firms’ survival likelihood reduces almost three times, while the risk of banking crises doubles. This entails further costs, that is an additional fiscal burden of approximately 5% to 15% of GDP per year to absorb losses and rescue insolvent banks”.

The fact that climate change will negatively impact the economic growth, affecting the productivity of labour and the stock of capital owned by firms, is a well-known finding. This study on Nature Climate Change underlines that these events will be exacerbated by the effects, so far unexplored, on the global banking system.

“We discussed”, adds Valentina Bosetti, senior scientist at RFF-CMCC European Institute on Economics and the Environment and Prof. at Bocconi University in Milan, “about the direct damages that climate change exerts on economic growth while trying to establish the contribution of climate-induced financial distress to such a shrinkage of economic performances. We found out that around 20% of growth rates reduction observed is attributable to financial distress”.

Another interesting result of this study focused on the possible measures that financial regulation authorities can implement to manage and reduce climate-related risks. Researchers tested in particular whether macro-prudential policies can help mitigate the costs of banks’ bailouts. “The study highlights”, says Andrea Roventini, Prof. at Scuola Superiore Sant’Anna in Pisa, “that financial regulation authorities can modify banks’ capital requirements, accounting for the impacts of climate damages on firms’ solvency while reducing risks to the financial sector”.

Therefore, the authors note that leaving out the financial system from climate-economy integrated assessment may lead to an underestimation of climate impacts, and that financial regulation can play a role in mitigating them. Nonetheless, even if macro-prudential regulation is in place, the impact of climate change on financial crises remains dominant. This calls for the association of macro-prudential policies with broader and more effective adaptation and mitigation strategies while fostering investments towards low carbon projects.

Link to the article on Nature Climate Change:
Francesco Lamperti, Valentina Bosetti, Andrea Roventini, Massimo Tavoni “The public costs of climate-induced financial instability”, Nature Climate Change, DOI: 10.1038/s41558-019-0607-5