Climate-Risk and Financial Stability

Climate change is not just an environmental issue. From challenges securing mortgages in areas prone to hurricanes and wildfires, to the impact of carbon taxes on disposable income, its ripple effects pose significant threats to financial stability. 

In this video, Alison Taylor, assistant professor of finance at Smith School of Business, breaks down how climate change is creating new challenges for businesses. She explores its direct and indirect impacts on the economy. She also explains how banks are adapting, especially in lending and investment, by using smarter risk management strategies.  

Her research offers frameworks for organizations to prepare for potential risks to future financial stability, and to remain agile in times of uncertainty. 

[MUSIC PLAYING]  

Alison Taylor 

00:07: What impacts can climate-risk have on financial stability? 

When we talk about climate risk, there's broadly two main categories. The first is the physical. So, the direct effects. Climate change is affecting businesses, weather through hurricanes, forest fires, flooding, et cetera.  

And then there's also the indirect effects, so a carbon tax or uncertainty about how regulation is going to go through, how consumer preferences are going to change. These are all things that can also affect a business. And when we're talking about banking, we're really thinking about the investments that they've made and how much those are going to be affected by climate change.  

00:46: What are the primary climate-related risks that banks face? 

So essentially, when we're talking about risk for banks, we're really worried about a situation where they make investments, they expect to get a certain amount of income per month and then they unexpectedly have less than they're predicting. And then it's hard for them to then make the payments that they've promised to other people.  

So, whether it's climate risk, whether it's inflation, whether it's interest rate risk, essentially making sure that banks are thinking about the risk holistically; they're considering all possible scenarios.

The reason why I'm so interested in banks is because they're really the heart of the economy.  So, if the banking sector is affected, that could potentially lead to a recession because they're the ones who lend to businesses. And the challenge with banks is they're so integrated with each other. So, if one bank is affected, they lend with each other so then maybe they have a hard time paying back another bank and then that bank now is affected as well.  

Another challenge with this area is essentially the unexpected feedback effects. One example of this is a carbon tax, which it's pretty clear to think that would affect the energy sector. So, if I'm in a bank and I'm lending to the energy sector, of course, I'd be worried about the carbon tax.  

But what can also be affected is other industries. For example, if there's a carbon tax, if energy is more expensive, if food prices are more expensive, people don't eat out at restaurants as much. So, the restaurant sector, even if there's fully compostable material, even if they're green in all the ways that you would be thinking about, a carbon tax could affect them indirectly because people have less disposable income.

02:36: What do your investigations find? 

For one of my projects I look at U.S. banks and whether they're thinking about hurricanes when they give out household mortgage loans. Because basically, there's expected to be a doubling of severe hurricanes by the end of the century in the U.S., so banks should be thinking about this, especially in areas that are higher risk.  

And that's largely what I do find. In general, banks are adjusting as the climate science comes out on the increased concern about hurricane risk. But what's important is it's not the same for every bank. For some banks, especially those that are affected more by the financial crisis, they're less reactive to this news. So, they're effectively taking on more of these loans that are exposed to hurricane risk. If we're thinking back to financial stability, that might be more of a problem because those are the most fragile banks. They should be reacting the most and reducing their risk the most to this. But it seems as if they're preoccupied with trying to get enough cash and thinking about more conventional risk, that they're neglecting this emerging risk.  

03:54: What can investors take away from your research? 

For my research, I think there's a couple takeaways. For businesses individually, potentially they're going through a lot of difficulty, there's some kind of crisis. It makes sense to focus on it ­­— focus on the thing that's coming up in the next month. But after that crisis is over, think about the things that you neglected and catch up on — the things that you weren't able to do.

More broadly, I think what's helpful is allowing for nuance. I think often with this discussion it's very binary. We definitely have a problem, or we definitely don't have a problem. And that can be really enticing in times of uncertainty, where we really want someone to say, ‘we for sure are going to have this.’ But I think what's more realistic is a more nuanced take, where we may or may not have a problem, and that problem may or may not be large, and there's a chance that it could go a certain way. And then so when we're a business, I think it's helpful to have that perspective of it might not be the worst-case scenario, and it might not be the best-case scenario, but it might be somewhere in the middle and we should prepare for that situation.