Mispricing climate change may hurt financial stability, says ECB

Bloomberg

Climate change could hit bank balance sheets with a knock-on effect on financial stability, the European Central Bank (ECB) warned on Wednesday.
In a special feature for its semi-annual Financial Stability Review on Wednesday, the ECB said problems will materialise if markets aren’t correctly pricing the risks stemming from extreme weather events and the transition to a low-carbon emission economy.
“A deeper understanding of the relevance of climate change-related risks for the euro area financial system at large is therefore needed,” the ECB said. “Better data availability and comparability and the development of a forward-looking framework for risk assessments are important aspects of this work.”
Global warming is getting increased attention from the world’s central banks. Bank of England Governor Mark Carney and his French counterpart Francois Villeroy de Galhau warned in a joint article last month that policy makers cannot ignore the “obvious risks” related to climate change, urging financial industry and central bank to do more. The US Federal Reserve is also reportedly looking into the issue.
The ECB said weather events were responsible for over 80 percent of insured catastrophe losses in 2018, and “physical risks, when they materialise, can significantly erode collateral and asset values and have an impact on insurance liabilities.”
The central bank said the transition to a low-carbon-emission economy will affect some companies more than others and therefore expose the banks that are intertwined with them.
Policy makers need to get a better grip on the scale of that exposure as a lack of reliable and comparable data “could create uncertainty and cause pro-cyclical market dynamics, including fire sales of carbon-intensive assets, and potentially also liquidity problems.”
The ECB also warned of corporate debt in its Financial Stability Review. Risks to the euro zone’s public and private finances have risen in the past six months, with indebted companies especially exposed, it said.
The central bank said downside economic risks remain “prominent” and market volatility at the start of the year highlighted how a sudden rise in funding costs could hurt debt-laden companies and governments. There was also a gloomy prognosis for the banking industry with a warning that profitability, already weaker than that of international peers, will remain below levels demanded by investors.
Still, the ECB didn’t follow the argument of many lenders that its negative interest rates are to blame. Instead it said fault lies with banks themselves, saying the main issues are high cost structures, limited revenue diversification and “legacy assets” — essentially non-performing loans.
On the positive side, it said capital adequacy is strong, implying “widespread resilience to plausible adverse scenarios.”
The Frankfurt-based central bank said it’s concerned over debt sustainability for some governments, which could face difficulty refinancing if investors reassess the risk of
sovereign bonds.
A number of euro-zone countries have struggled to get their borrowing under control, while six years of economic expansion buoyed by ultra-low interest rates have seen some companies pile up debts.