by Celso Brunetti, John Caramichael, Matteo Crosignani, Benjamin Dennis, Gurubala Kotta, Don Morgan, Chaehee Shin, and Ilknur Zer Boudet
Abstract: This report has two objectives: 1. Review the available literature on Climate-Related Financial Stability Risks (CRFSRs) as it pertains to the United States. Specifically, the literature review considers several modeling approaches and aims to 1.1 Identify financial market vulnerabilities (e.g., bank leverage), 1.2 Provide an assessment of those vulnerabilities (high/medium/low) as identified by the current literature, and 1.3 Evaluate the uncertainty surrounding these assessments based on interpretation of the findings and coverage of existing literature (high/low). 2. Identify methodologies to link climate risks to financial stability and possible research paths to assess U.S. CRFSRs. The report is structured in three parts. First, it characterizes the potential financial system vulnerabilities of climate change. Second, it describes the major methodologies adopted in studying the implications of climate change and provides an assessment of financial system vulnerabilities identified by the current literature. Third, it discusses how different methodologies can be further developed or combined to assess U.S. CRFSRs.
The paper contains four key findings: First, modelling and assessing CRFSRs present several challenges, and no single methodology can address all of them: (1) accounting for uncertainty, (2) adapting to long time horizons, (3) embedding heterogeneity, (4) incorporating technological change, and (5) modeling damage functions to measure the economic impacts of climate change. The paper highlights the limitations of the methodologies considered and the need for further research.
Second, the literature on U.S. CRFSRs is thin and identifies only a few U.S. financial system vulnerabilities.
Third, currently available results should be interpreted with caution. The paper considers the number of studies available for the assessment, the modelling assumptions behind those studies, and the overall qualitative evaluation of the results, and concludes that any assessment based on the extant literature is characterized by a large degree of uncertainty.
Fourth, no methodology can be used in isolation to fully assess U.S. CRFSRs; several methodologies need to be combined for a more complete understanding. For example, the reduced form outputs from micro- and macro-econometric statistical methods can be used to inform the main parameters and assumptions in computable general equilibrium and dynamic stochastic general equilibrium models, as well as the distributions of different random variables in agentbased models. In turn, equilibrium models and agent-based models can be used to design scenarios that feed into scenario analysis, sensitivity analysis, stress testing, and other practitioner approaches.
Report (47 pages):
https://www.federalreserve.gov/econres/feds/climate-related-financial-stability-risks-for-the-united-states.htm