Emerging risks for risk mitigators: how financial market infrastructures can address climate-related financial risk

Policymakers, regulators and other stakeholders are increasingly focusing on the financial risks associated with climate change, with some publicly stating that climate-related risk could have such a far-reaching structural impact, that it poses a potential threat to global financial stability.

Given that the effects of climate change we have observed thus far will likely be eclipsed by more extreme shifts in years to come, it’s important to better understand its complex impacts on the financial ecosystem. It’s equally important to recognize that financial market infrastructures (FMIs) are affected by climate-related financial risk differently than other types of financial institutions, given their distinct roles.

Even though physical damage is the most tangible manifestation of climate-related risk, we should also consider transition risk, which is the risk that the shift towards a low-carbon economy could be unpredictable or disorderly – and therefore could cause economic losses. While carbon-intensive industries are directly exposed to this type of risk, transition risk can indirectly affect banks as well, given their role in financing industrial companies. FMIs on the other hand are far less exposed to transition risk, not only because it represents a third-order type of exposure to them, but also because the risk horizon of FMIs is considerably shorter than that of financial institutions.

That said, with climate change anticipated to worsen, it is important to consider how FMIs should address climate-related financial risk. In a recent whitepaper, DTCC identified several areas where FMIs can take action to better manage and prepare for climate-related risk.

First, FMIs should consider the merits of adding climate-related trending metrics to their business continuity programs to effectively monitor and manage their exposure to physical risk. For example, DTCC’s Business Continuity department recently implemented a climate change component into its business continuity risk profiles. These risk profiles analyse business areas against a wide variety of control qualifiers and are folded into overarching operational risk profiles for the entire enterprise.

Second, FMIs should also consider how they can include climate-related risk data to better assess counterparty credit exposure, compliance controls and governance. Standardization around disclosure requirements across the financial services industry is a key prerequisite for FMIs to accurately assess their clearing members’ climate-related financial exposures as part of their counterparty credit risk monitoring processes. The timely issuance of a final global baseline climate reporting standard is critical given the worldwide market demand for consistent, comparable and actionable disclosures on climate-related risks and opportunities. There is also a growing recognition of the need for global assurance standards to support the reliability of these disclosures.

Third, the use of scenario analysis is also worth exploring to better understand the potential impacts of climate-related financial risk. However, the accuracy of climate-related scenario testing depends on two fundamental requirements: having robust quantitative data that can serve as scenario inputs and establishing clear causational relationships between such inputs and the testing results. Given that additional work is needed to further develop these prerequisites to the point where they can be applied for modelling purposes with a sufficient degree of confidence, the practical usefulness of climate-related scenario testing remains limited at this time.

Fourth, as the understanding of climate-related risk matures, it is important that FMIs continue to focus on their key mandate of safeguarding financial stability in stressed market conditions. This mandate should remain the central tenet to any regulatory framework that might be applied to ensure that FMIs adequately address the emergence of climate-related financial risk. For the continued safety of the global financial system, FMIs should not be required to either directly or indirectly trade-off market and liquidity risks to address climate-related financial risk.

Today, the Principles for Financial Market Infrastructures (PFMIs) that were issued by CPMI-IOSCO remain the foundational policy tool with respect to FMIs’ risk management practices. These internationally developed principles provide a comprehensive and adaptative framework that has been implemented in the U.S. by the CFTC, the Federal Reserve and the SEC. They were specifically designed to ensure that FMIs are optimally equipped to preserve financial stability. As such, these principles contain effective guidance that FMIs can already leverage to adequately and appropriately address the challenges created by current and future climate-related risks.

In summary, FMIs are well-equipped to address climate-related risks – partially because their processes and controls are specifically designed to withstand extreme levels of operational and financial stress, and partially because their short risk horizon makes them less sensitive to risks that could materialize over medium and longer-term timeframes. As FMIs seek to anticipate additional challenges posed by climate change, they should focus on ways to incorporate climate-related data into their business continuity programs and their counterparty credit risk assessments.