For release on delivery
10:30 a.m. EDT (4:30 p.m. local time)
May 11, 2023
Climate Change and Financial Stability
Remarks by
Christopher J. Waller
Member
Board of Governors of the Federal Reserve System
at
IE University - Banco de España - Federal Reserve Bank of St. Louis Conference
Current Challenges in Economics and Finance
Madrid, Spain
May 11, 2023
Thank you for inviting me to speak today.
Climate change is real, but I do not believe it poses a serious risk to the safety and
soundness of large banks or the financial stability of the United States.1 Risks are risks.
There is no need for us to focus on one set of risks in a way that crowds out our focus on
others. My job is to make sure that the financial system is resilient to a range of risks.
And I believe risks posed by climate change are not sufficiently unique or material to
merit special treatment relative to others.2 Nevertheless, I think it's important to continue
doing high-quality academic research regarding the role that climate plays in economic
outcomes, such as the work presented at today's conference.
In what follows, I want to be careful not to conflate my views on climate change
itself with my views on how we should deal with financial risks associated with climate
change. I believe the scientific community has rigorously established that our climate is
changing. But my role is not to be a climate policymaker. Consistent with the Fed's
mandates, I must focus on financial risks, and the questions I'm exploring today are about
whether the financial risks associated with climate change are different enough from
other financial stability risks to merit special treatment. But before getting to those
questions, I'd like to briefly explain how we think about financial stability at the Federal
Reserve.
Financial stability is at the core of the Federal Reserve and our mission. The
Federal Reserve was created in 1913, following the Banking Panic of 1907, with the goal
of promoting financial stability and avoiding banking panics. Responsibilities have
evolved over the years. In the aftermath of the 2007-09 financial crisis, Congress
assigned the Fed additional responsibilities related to promoting financial stability, and
the Board of Governors significantly increased the resources dedicated to that purpose.
Events in recent years, including the pandemic, emerging geopolitical risks, and recent
stress in the banking sector have only highlighted the important role central banks have in
understanding and addressing financial stability risks. The Federal Reserve's goal in
financial stability is to help ensure that financial institutions and financial markets remain
able to provide critical services to households and businesses so that they can continue to
support a well-functioning economy through the business cycle.
Much of how we think about and monitor financial stability at the Federal
Reserve is informed by our understanding of how shocks can propagate across financial
markets and affect the economy. Economists have studied the role of debt in the
macroeconomy dating all the way back to Irving Fisher in the 1930s, and in the past 40
years it has been well established that financial disruptions can reduce the efficiency of
credit allocation and have real effects on the broader economy.3 When borrowers'
financial conditions deteriorate, lenders tend to charge higher rates on loans. That, in
turn, can lead to less overall lending and negatively affect the broader economy.4 And in
the wake of the 2007-09 financial crisis, we've learned more about the important roles
credit growth and asset price growth play in "boom-bust" cycles.5
Fundamentally, financial stress emerges when someone is owed something and
doesn't get paid back or becomes worried they won't be paid back. If I take out a loan
from you and can't repay it, you take a loss. Similarly, if I take out a mortgage from a
bank and I can't repay it, the bank could take a loss. And if the bank hasn't built
sufficient ability to absorb those losses, it may not be able to pay its depositors back.
These dynamics can have knock-on effects on asset prices. For example, when people
default on their home mortgage loans, banks foreclose and seek to sell the homes, often at
steep discounts. Those foreclosure sales can have contagion effects on nearby house
prices.6 When a lot of households and businesses take such losses around the same time,
it can have real effects on the economy as consumption and investment spending take a
hit and overall trust in financial institutions wanes. The same process works when
market participants fear they won't be paid back or be able to sell their assets. Those
fears themselves can drive instability.
The implication is that risks to financial stability have a couple of features. First,
the risks must have relatively near-term effects, such that the risk manifesting could result
in outstanding contracts being breached. Second, the risks must be material enough to
create losses large enough to affect the real economy.
These insights about vulnerabilities across the financial system inform how we
think about monitoring financial stability at the Federal Reserve. We identify risks and
prioritize resources around those that are most threatening to the U.S. financial system.
We distinguish between shocks, which are inherently difficult to predict, and
vulnerabilities of the financial system, which can be monitored through the ebb and flow
of the economic cycle. If you think about it, there is a huge set of shocks that could hit at
any given time. Some of those shocks do hit, but most do not. Our approach promotes
general resiliency, recognizing that we can't predict, prioritize, and tailor specific policy
around each and every shock that could occur.7
Instead, we focus on monitoring broad groups of vulnerabilities, such as
overvalued assets, liquidity risk in the financial system, and the amount of debt held by
households and businesses, including banks. This approach implies that we are
somewhat agnostic to the particular sources of shocks that may hit the economy at any
point in time. Risks are risks, and from a policymaking perspective, the source of a
particular shock isn't as important as building a financial system that is resilient to the
range of risks we face. For example, it is plausible that shocks could stem from things
ranging from increasing dependence on computer systems and digital technologies to a
shrinking labor force to geopolitical risk. Our focus on fundamental vulnerabilities like
asset overvaluation, excessive leverage, and liquidity risk in part reflects our humility
about our ability to identify the probabilities of each and every potential shock to our
system in real time.
Let me provide a tangible example from our capital stress test for the largest
banks. We use that stress test to ensure banks have sufficient capital to withstand the
types of severe credit-driven recessions we've experienced in the United States since
World War II.8 We use a design framework for the hypothetical scenarios that results in
sharp declines in asset prices coupled with a steep rise in the unemployment rate, but we
don't detail the specific shocks that cause the recession because it isn't necessary. What
is important is that banks have enough capital to absorb losses associated with those
highly adverse conditions. And the losses implied by a scenario like that are huge: last
year's scenario resulted in hypothetical losses of more than $600 billion for the largest
banks. This resulted in a decline in their aggregate common equity capital ratio from
12.4 percent to 9.7 percent, which is still more than double the minimum requirement.
That brings us back to my original question: Are the financial risks stemming
from climate change somehow different or more material such that we should give them
special treatment? Or should our focus remain on monitoring and mitigating general
financial system vulnerabilities, which can be affected by climate change over the long-
term just like any number of other sources of risk? Before I answer, let me offer some
definitions to make sure we're all talking about the same things.
Climate-related financial risks are generally separated into two groups: physical
risks and transition risks. Physical risks include the potential higher frequency and
severity of acute events, such as fires, heatwaves, and hurricanes, as well as slower
moving events like rising sea levels. Transition risks refer to those risks associated with
an economy and society in transition to one that produces less greenhouse gases. These
can owe to government policy changes, changes in consumer preferences, and technology
transitions. The question is not whether these risks could result in losses for individuals
or companies. The question is whether these risks are unique enough to merit special
treatment in our financial stability framework.
Let's start with physical risks. Unfortunately, like every year, it is possible we
will experience forest fires, hurricanes, and other natural disasters in the coming months.
These events, of course, are devastating to local communities. But they are not material
enough to pose an outsized risk to the overall U.S. economy.
Broadly speaking, physical risks could affect the financial system through two
related channels. First, physical risks can have a direct impact on property values.
Hurricanes, fires, and rising sea levels can all drive down the values of properties. That
in turn could put stress on financial institutions that lend against those properties, which
could lead them to curb their lending, and suppress economic growth. The losses that
individual property owners can realize might be devastating, but evidence I've seen so far
suggests that these sorts of events don't have much of an effect on bank performance.9
That may be in part attributable to banks and other investors effectively pricing physical
risks from climate change into loan contracts. For example, recently researchers have
found that heat stress-a climate physical risk that is likely to affect the economy-has
been priced into bond spreads and stock returns since around 2013.10 In addition, while it
is difficult to isolate the effects of weather events on the broader economy, there is
evidence to suggest severe weather events like hurricanes do not likely have an outsized
effect on growth rates in countries like the United States.11
Over time, it is possible some of these physical risks could contribute to an
exodus of people from certain cities or regions. For example, some worry that rising sea
levels could significantly change coastal regions. While the cause may be different, the
experience of broad property value declines is not a new one. We have had entire
American cities that have experienced significant declines in population and property
values over time. Take, for example, Detroit. In 1950, Detroit was the fifth largest city
in the United States, but now it isn't even in the top 20, after losing two-thirds of its
population. I'm thrilled to see that Detroit has made a comeback in recent years, but the
relocation of the automobile industry took a serious toll on the city and its people. Yet
the decline in Detroit's population, and commensurate decline in property values, did not
pose a financial stability risk to the United States. What makes the potential future risk
of a population decline in coastal cities different?
Second, and a more compelling concern, is the notion that property value declines
could occur more-or-less instantaneously and on a large scale when, say, property
insurers leave a region en masse. That sort of rapid decline in property values, which
serve as collateral on loans, could certainly result in losses for banks and other financial
intermediaries. But there is a growing body of literature that suggests economic agents
are already adjusting behavior to account for risks associated with climate change.12 That
should mitigate the risk of these potential "Minsky moments."13 For the sake of
argument though, suppose a great repricing does occur; would those losses be big enough
to spill over into the broader financial system? Just as a point of comparison, let's turn
back to the stress tests I mentioned earlier. Each year the Federal Reserve stresses the
largest banks against a hypothetical severe macroeconomic scenario. The stress tests
don't cover all risks, of course, but that scenario typically assumes broad real estate price
declines of more than 25 percent across the United States. In last year's stress test, the
largest banks were able to absorb nearly $100 billion in losses on loans collateralized by
real estate, in addition to another half a trillion dollars of losses on other positions.14
What about transition risks? Transition risks are generally neither near-term nor
likely to be material given their slow-moving nature and the ability of economic agents to
price transition costs into contracts. There seems to be a consensus that orderly
transitions will not pose a risk to financial stability.15 In that case, changes would be
gradual and predictable. Households and businesses are generally well prepared to adjust
to slow-moving and predicable changes. As are banks. For example, if banks know that
certain industries will gradually become less profitable or assets pledged as collateral will
become stranded, they will account for that in their loan pricing, loan duration, and risk
assessments. And, because assets held by banks in the United States reprice in less than
five years on average, there is ample time to adjust to all but the most abrupt of
transitions.16
But what if the transition is disorderly? One argument is that uncertainty
associated with a disorderly transition will make it difficult for households and businesses
to plan. It is certainly plausible that there could be swings in policy, and those swings
could lead to changes in earnings expectations for companies, property values, and the
value of commodities. But policy development is often disorderly and subject to the
uncertainty of changing economic realities. In the United States, we have a long history
of sweeping policy changes ranging from revisions to the tax code to things like changes
in healthcare coverage and environmental policies. While these policy changes can
certainly affect the composition of industries, the connection to broader financial stability
is far less clear. And when policies are found to have large and damaging consequences,
policymakers always have, and frequently make use of, the option to adjust course to
limit those disruptions.
There are also concerns that technology development associated with climate
change will be disorderly. Much technology development is disorderly. That is why
innovators are often referred to as "disruptors." So, what makes climate-related
innovations more disruptive or less predictable than other innovations? Like the
innovations of the automobile and the cell phone, I'd expect those stemming from the
development of cleaner fuels and more efficient machines to be welfare-increasing on
net.
So where does that leave us? I don't see a need for special treatment for climate-
related risks in our financial stability monitoring and policies. As policymakers, we must
balance the broad set of risks we face, and we have a responsibility to prioritize using
evidence and analysis. Based on what I've seen so far, I believe that placing an outsized
focus on climate-related risks is not needed, and the Federal Reserve should focus on
more near-term and material risks in keeping with our mandate.
I'd be happy to take a few questions.
References
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"Is Physical Climate Risk Priced? Evidence from Regional Variation in Exposure to
Heat Stress." Working Paper 30445. National Bureau of Economic Research.
https://www.nber.org/system/files/working_papers/w30445/w30445.pdf.
Bernanke, Ben S. 1983. "Non-Monetary Effects of the Financial Crisis in the Propagation
of the Great Depression." The American Economic Review 73 (3): 257-76.
Bernanke, Ben S., Mark Gertler, and Simon Gilchrist. 1999. "The Financial Accelerator
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Bickel, Kristian, Sarah N. Hamerling, and Donald P. Morgan. 2021. "How Bad Are
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Financial Stability Board. 2020. "The Implications of Climate Change for Financial
Stability."
https://www.fsb.org/2020/11/the-implications-of-climate-change-forfinancial-stability/.
Financial Stability Oversight Council. 2021. "Report on Climate-Related Financial Risk."
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Harding, John P., Eric Rosenblatt, and Vincent W. Yao. 2009. "The Contagion Effect of
Foreclosed Properties." Journal of Urban Economics 66, no. 3 (November): 164-78.
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Jordà, Òscar, Moritz Schularick, and Alan M. Taylor. 2013. "When Credit Bites Back."
Journal of Money, Credit and Banking 45, no. s2 (December): 3-28.
https://doi.org/10.1111/jmcb.12069.
Kiley, Michael T. 2021. "What Macroeconomic Conditions Lead Financial Crises?"
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https://doi.org/10.1016/j.jimonfin.2020.102316
Linder, M. Henry, Richard Peach, and Sarah Stein. 2013. "The Effect of Superstorm
Sandy on the Macroeconomy." Liberty Street Economics. Federal Reserve Bank of
New York.
https://libertystreeteconomics.newyorkfed.org/2013/04/the-effect-ofsuperstorm-sandy-on-the-macroeconomy/.
Meisenzahl, Ralf. 2023. "How Climate Change Shapes Bank Lending: Evidence from
Portfolio Reallocation." Working Paper No. 2023-12. Federal Reserve Bank of
Chicago. http://dx.doi.org/10.2139/ssrn.4405234.
Schularick, Moritz, and Alan M. Taylor. 2012. "Credit Booms Gone Bust: Monetary
Policy, Leverage Cycles, and Financial Crises, 1870-2008." American Economic
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https://www.aeaweb.org/articles?id=10.1257/aer.102.2.1029.