IMF Outlines Approaches to Climate Risk Analysis

Climate risk analysis typically entails the development of scenario-based stress tests for assessing bank solvency and liquidity, using bank level data.

The International Monetary Fund (IMF) has released a paper on approaches to climate risk analysis, as part of its efforts to help prepare the financial sector for a successful transition to a lower carbon global economy.

The paper includes a primer on climate change risk, both transition and physical, explaining some of the technical terms and concepts used in this work. It also lays out the IMF staff’s emerging approach to assessing the impact of climate change on banking sector stability risks conducted in the context of the IMF’s Financial Sector Assessment Programme (FSAP).

The paper explains the approach to standard risk analysis in FSAPs, and how this would be modified in broad terms to incorporate climate risk.

“Climate risk analysis considered by IMF staff is not a standard stress test,” the paper says. “Unlike conventional stress testing, climate risk analysis is not currently focused on quantifying possible capital needs of financial institutions relative to regulatory minimum requirements.”

The paper also discusses different approaches to the analysis of physical versus transition risk, their implications for the macro-economy and across sectors in the real economy and different geographies – and how all these effects map into the banking sector.

It uses examples from recent FSAPs to illustrate concepts, taking note of the challenges confronting this work – including data gaps, uncertainty regarding climate projections, and long simulation horizons in conducting the climate risk analysis.

The paper focuses on the methods being deployed by IMF staff to raise awareness of the climate risks and adaptation needs, highlighting a need for banks to develop tools to manage these risks and for financial sector supervisory authorities to adequately supervise this risk.

“Climate risk analysis requires assumptions on the potential future paths for global emissions of greenhouse gases—and thus temperatures—and their effects,” the paper says. “These are dependent on many factors, not least policies to reduce emissions, develop new technologies, and foster adaptation and resilience to the effects of climate change.”

FSAP risk analysis typically entails the development of scenario-based stress tests for assessing bank solvency and liquidity, and running top-down exercises on bank level data with some degree of sectoral break-down.

The most basic component of an FSAP stress test is top-down solvency analysis, which assesses credit, market, interest, and FX risks, and their impact on bank profitability and capitalisation over a 3–5 year stress testing horizon.

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