Climate risk and financial stability in the network of banks and investment funds

We analyze the effects on financial stability of the interplay between climate transition risk and market conditions, such as recovery rate and asset price volatility. To this end, we extend the framework of the climate stress-test of the financial system by including an ex-ante network valuation of financial assets which accounts for asset price volatility as well as for endogenous recovery rate on interbank assets. Moreover, we also consider the dynamics of indirect contagion of banks and investment funds, which are key players in the low carbon transition, via exposures to the same asset classes. We derive some analytical results and we apply the model to a unique supervisory dataset in a range of climate policy scenarios and market conditions. In the event of a disorderly low-carbon transition, stronger market conditions allow to reach more ambitious climate policies at the same level of financial risk. (c) 2021 Elsevier B.V. All rights reserved.

Automated summary

This study examines the impact of climate transition risk and market conditions on financial stability, introducing a new framework and model to analyze the valuation of financial assets and indirect contagion between banks. It finds that in the event of a disorderly low-carbon transition, stronger market conditions can support more ambitious climate policies.