Financial sector risks and supervision in the midst of climate change

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Deputy Managing Director, Bo Li
      • Deputy Managing Director Bo Li’s Keynote Speech at the 59th Bi-Annual Meeting of CARICOM Central Bank Governors, Nassau

By Bo Li

Over the last three years, we have seen shock upon shock upon shock hit the global economy and each has struck the shores of the Caribbean. The pandemic devastated tourism, causing double-digit declines in GDP in 2020. The war in Ukraine further stoked food and fuel price spikes that have broadened into stubborn inflation. And all the while, natural disasters have continued to grow more frequent and severe due to climate change an existential threat to this region and to our planet.

Indeed, as Bahamians marked the third anniversary of the utter devastation of hurricane Dorian, the recovery still continues. That single storm inflicted damage equivalent to one-quarter of annual output. And across the region disaster-related damage in the last decade has been three times what it was in the 1990s.

Nonetheless, the region’s financial systems have been resilient to climate-related shocks. This reflects the rapid rebound in tourism and other activity following shocks, insurance payouts, and banks’ limited credit exposures to the agriculture and tourism sectors. And importantly, it reflects your work – the rapid financial assistance provided by governments and central banks to affected firms and households.

The financial system’s role in helping people rebuild in honoring claims after major storms highlights its importance to improving resilience to climate change.

However, insurance penetration in the Caribbean relative to climate-related damages is generally lower than in Latin America, due to the high upfront costs of insurance products, concerns that significant damages may not trigger payouts, and competing developmental needs.

Consequently, governments often need to provide financial support to repair damaged public infrastructure and assist uninsured households. This increases public debt and the risks to domestic financial institutions who hold it.

These risks will only grow as climate change intensifies. Successive storms may delay economic recoveries for longer and may even deter private investment.

Recent IMF simulations for the Eastern Caribbean Currency Union suggest that more frequent hurricanes could have pronounced effects on the quality of banks’ loan portfolios, depending on the country’s fiscal, monetary, and prudential policy responses, its dependence on tourism, and the sectoral composition of banks’ loan books.

Overall, while much of the region boasts well-capitalized financial institutions, these events could significantly reduce their profitability and solvency, constraining lending and investment.

With this in mind, let me focus on three priority areas for central bankers and financial regulators.

First, acting to systematically incorporate climate risk assessments into financial stability frameworks. This will help improve understanding of the financial stability risks both from climate events, and from policies to transition the economy out of fossil fuels.

The IMF plays a catalytic role in this area through our financial sector assessment programs (FSAPs), a comprehensive and in-depth assessment of a country or currency area’s financial sector.

In FSAPs, we integrate material and systemically important climate risks into our overall evaluation of the financial sector. For instance, recent IMF country reports and financial sector assessments for the Caribbean have incorporated analyses related to climate risk. These included assessing banks’ capacities to absorb losses from natural disasters and advice on how to integrate physical climate risk scenarios into regulators’ financial system crisis management plans.

For example, the 2019 financial sector assessment for The Bahamas includes a natural disaster scenario of a major hurricane negatively impacting tourism, employment, and bank asset quality, with negative repercussions for banks’ capital ratios. This analysis, which featured a tail risk scenario of storm damages of 22 percent of annual output, could not have been timelier: just two months after its publication, hurricane Dorian hit The Bahamas, with actual outcomes very close to what had been considered a very low-risk scenario.

The second area I would like to focus on is the importance of incorporating climate risks into the prudential framework.

Promoting the safety and soundness of financial institutions and the financial system requires ensuring that climate-related risks are adequately captured in the regulatory framework and the supervision process, particularly in climate-vulnerable countries like those in the Caribbean.

Allocating adequate resources and building internal capacity for supervision of climate risks is one important area. Setting guidelines for financial institutions on governance and strategy, risk management, scenario analysis and risk assessments, and disclosure of climate risks are also important. Improving data collection from financial institutions to better monitor their exposure to climate-related risks is a priority.

In response to greater risks, financial regulators in the Caribbean have already made material strides to incorporate climate risks into their regulatory and supervisory frameworks. For example, several regulators now incorporate some form of scenario analysis to assess financial institutions’ capacities to absorb losses from natural disasters. Similarly, work has begun on the development of real estate price indices, which would enhance market monitoring, collateral valuation for mortgages, and the setting of lending standards.

However, there is scope to further integrate physical climate risks into regional and national supervisory frameworks, including by tailoring risk assessments to incorporate scenarios that account for not only more intense or frequent storms, but also the resilience of critical infrastructure.

Moreover, we urge authorities to develop regulatory measures to support climate risk-aware lending practices, the adequacy of prudential risk buffers, particularly for systemic institutions, and ex-post asset recovery. Equally important is for financial institutions to avoid excessive concentration to a single insurer, sector, or sovereign. The implementation of loan-to-value and debt-to-income-based mortgage lending standards in some countries would also increase the resilience of mortgagors to natural disasters.

Increasing insurance penetration in the region is also important to minimizing the losses to the state and limiting the rise in public debt and sovereign credit risk sometimes witnessed after natural disasters. Our own work has found that the demand for private insurance penetration tends to increase after major natural disasters. However, insurance penetration is also positively correlated with financial deepening and inclusion, suggesting that efforts to foster greater financial deepening and access could stimulate insurance penetration in countries with sizeable climate risks, including those that have not suffered from major natural disasters more recently.

The Caribbean Catastrophe Risk Insurance Facility (CCRIF), established in 2007, has been important to improving the region’s insurance coverage, but more action is needed.

Regional authorities should continue to build knowledge and expertise in climate-related risks. The IMF is helping our members build capacity through workshops and webinars in our Caribbean Regional Technical Assistance Centre.

Most recently, these included training on the compilation of residential property price indices, developing models to assess the insurance industry’s resilience to the impacts of natural disasters, and how to advance financial inclusion and dealing with climate risks.

This has contributed to strong progress in climate-related macroprudential monitoring and modelling in the last two years. And we’re committed to doing even more.

My third point is on climate information architecture. The region and the world urgently need more high-quality and reliable data, harmonized and comparable disclosures, and alignment on taxonomies.

A strengthened information architecture will help better assess climate risks, allow accurate market pricing, enable informed investment decisions, and facilitate the growth of climate finance.

The IMF is actively engaged on this with the World Bank, Bank for International Settlements, and Organization for Economic Cooperation and Development to develop operational guidance on the G20 high-level principles for sustainable finance alignment approaches including taxonomies.

The “Bridging data gaps” workstream of the Network for Greening the Financial System (NGFS) co-chaired by the IMF – has pioneered a constructive dialogue on important data issues.

We also provide financing. Our Resilience and Sustainability Trust is now operational, with two of our first loans going to nearby countries Barbados and Costa Rica. The RST will help countries make the long-term investments needed to meet long-term challenges like climate.

And as we gear up to do even more, we want to hear from our members. I trust that your deliberations at these meetings will help illuminate the way forward.

IMF Communications Department

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