Blog: How to prevent the next banking crisis? Lean in on climate now.

How to prevent the next banking crisis? Lean in on climate now.
Instead of waiting on perfect models that will never come.

By Alex Martin and Jessica Garcia

The banking crisis of 2023, an event appearing on few bingo cards, has thrown a harsh light on the urgency of managing the multitude of crises that the world now faces – climate change being the most existential of them. Factor in the vexing problem that economists have repeatedly underestimated the economic impacts of climate change and we have a straightforward case for proactively hardening the financial system against its effects.

Silicon Valley Bank failed because, in addition to serious federal policy failures, its leadership flubbed the basic task of managing widely anticipated interest rate hikes. The facts of climate change, painstakingly pronounced by climate scientists for decades, are no less obvious.

The term “polycrisis,” popularized by historian Adam Tooze to describe the interlocking challenges the world faces, has never been more relevant. New risks abound – climate change, cybersecurity, and pandemics – and it has become clear this year that financial instability is part of the package, both in the United States, in Europe and in the developing world

Richard Bookstaber, an expert in risk management, put it bluntly: the effects of these risks “will range somewhere between economic regime shift and existential threat to civilization.” 

Climate change poses a serious threat to individual banks and the financial system as a whole due to market, credit, liquidity, and operational risks driven by climate-related physical impacts and the inevitable transition to a low-carbon economy. U.S. financial regulators agree that climate financial risk requires mitigation, but their steps have been timid at best. 

And it can be mitigated, but only if regulators and financial institutions deploy a proactive, precautionary approach that recognizes, in the words of one group of scholars, the “radical uncertainty” that climate has injected into the financial system. 

Improved forecasting, metrics, and governance of climate financial risks will be essential, as will recognizing the limitations of overreliance on economic models, which Bookstaber observed, don’t work when our economy is weird.” 

Only a precautionary approach can grapple with complex and interconnected climate-driven economic threats. Uncertainty about precise impacts, timing, and how risks would unfold are bad reasons for inaction. 

While we can’t forecast the exact timing and location of climate impacts, we know the economic costs are staggering, growing, and consistently underestimated by economists and markets.

Since 1980, the United States has experienced 348 major weather and climate disasters with total costs exceeding $2.5 trillion dollars. In 2022 alone, 18 separate weather and climate disasters cost the U.S. $171 billion dollars all together in direct damages. Munich Re found that global losses from weather disasters are growing, reaching $270 billion in 2022 with only only 45 percent of those losses insured ($120 billion); before 2005 insured losses never exceeded $50 billion. 

Markets are also drastically mispricing climate risk, leading to the growth of climate and carbon bubbles. 

Real estate in the U.S. is estimated to be overvalued by $121-237 billion due to unpriced flood risk driven by climate change. Low-income households face the greatest risk of losing home equity, as was the case in the housing crash of 2007-08 that led to the financial crisis. 

Current fossil fuel assets face losses of around $1 trillion, and worse still banks are continuing to pour fuel on the fire by financing fossil fuel expansion. Troubling pockets of concentrated transition risk are growing in regional oil patch banks and in private equity, for example. 

Proactive regulation to meet the moment requires a precautionary approach to risk management and a qualitative and narrative approach to scenario analysis, grounded in the realities of climate science. Financial institutions and regulators must imagine extreme but plausible scenarios that will never be fully predicted or fully described by forward-looking economic modeling. But the Federal Reserve is currently using a narrow set of disconnected climate and transition scenarios

In all likelihood, climate shocks will be correlated, occurring in series and in parallel, and will affect many major institutions simultaneously, amplified by network effects. These systemic bubbles won’t deflate slowly, they will pop, perhaps many times over in a disorderly transition, and spill over into the broader economy.

Too many regulators are still acting as though climate only poses a narrow microprudential risk to individual institutions. This year’s banking crisis – duration unknown – has demonstrated that risk containment is difficult even when dealing with straightforward risks. 

To meet the moment, regulators must act now in the face of uncertainty in the new climate era using their full suite of tools, before climate change creates the next banking crisis – one that we can all see coming.