Risks don’t exist in isolation. They interact.
For example, concern has been growing recently about how climate change may interact with the financial system and cause serious financial risks to materialise.
There are three ways warming may affect the financial system directly.
- Money (investments, loans, etc) moves away from dirty sectors to clean ones leading to polluters defaulting on loans and bonds and their share price collapsing.
- Physical hazards – it is estimated that in the 1980s weather-related catastrophes caused $214 billion worth of damage at today’s prices; in the 2010s it was $1.62 trillion and rising. Initially this hits insurers but then the impact gets passed on.
- There is a sudden adjustment in economic view – a Minsky Moment (named after economist Hyman Minsky) – share prices fall across the board, borrowing costs soar, etc. When that happened in 2008, the assets causing the adjustment amounted to $1 trillion; now the assets in question – those of high-emitting industries – amount to around $50 trillion, so the expected impact may be 50 times greater.
Financial institutions are required to model these scenarios in stress tests, to measure the impact of all these risks occurring together. Sceptics say these tests are out-of-date and are unrealistically mild.
Nevertheless, running through scenarios, considering how risks interact, looking at how controls and early warning indicators work together, gives us a sense of how things might pan out. We just need to ask the question “what if….?”
If there is a conclusion from the scenarios that the banks have been running, it is that governments should no longer procrastinate because if they do, there will come a sudden need for action, a sudden adjustment in economic view – in short, a Minsky Moment – and that will not be pretty.
Data Sources: The Economist magazine, The New Yorker magazine, Investopedia, Wikipedia