Financial risks from climate-related shocks can spread through the financial system quickly, triggering company defaults and bank risks, according to a new report published today by European Central Bank (ECB) and the European Systemic Risk Board (ESRB).

The report, “The macroprudential challenge of climate change,” explores how climate shocks can affect the European financial system, particularly examining the systemic nature of climate risks, and discussing options for a coordinated European macroprudential policy response.

Among the key findings from the report was the interconnected nature of risks from climate transition and physical hazard-related issues, identifying several amplifiers of climate risk across the financial system. As an example, surging carbon prices could raise the likelihood of a company default leading to other defaults, magnifying transition risks for banks and companies.

Similarly, climate shocks caused by natural hazards such as water stress or wildfires could cause a sudden reassessment of climate risk pricing, triggering a “fire sale” dynamic with financial institutions liquidating affected securities at distressed prices. These dynamics are also exacerbated by the interdependent nature of natural hazards, which can often cluster together.

Climate risks also appear concentrated, according to the report, with more than 20% of potential losses residing in the holdings of 5% of euro area banks.

The report’s scenario analysis suggested that the impact of climate risks to the financial system would likely begin with market risk, with climate shocks affecting the portfolio valuations of investment funds, pension funds and insurance companies, and then extend to credit losses for banks as companies default.

Exploring the potential for macroprudential policies as part of a broader policy response to address the financial impact of climate change, the report proposes that these policies could work in tandem with supervisory efforts and microprudential regulation, with a focus on systemic aspects of climate-related risks. Applying a system-wide perspective, macroprudential policies would aim to address the risk from collective lending decisions by financial institutions, and help strengthen resilience of the financial system to losses when they materialize, with suggested measures such as systemic risk buffers or concentration thresholds.

The report follows the recent release by the ECB of its climate stress test, which indicated that significant work remains by most banks to sufficiently measure and manage climate-related risks, and identifying potential significant losses for banks under some scenarios. Earlier this month, the ECB announced a series of moves to further incorporate climate change considerations into its monetary policy framework, aimed at reducing financial risk to the Eurosystem balance sheet related to climate change and supporting the green transition of the economy.

Click here to access the ECB/ESRB report.