Central banks, financial stability and policy coordination in the age of climate uncertainty: a three-layered analytical and operational framework

Abstract

ABSTRACT This paper explores how climate change and the transition to a low-carbon economy pose new systemic financial risks (so-called Green Swans), and the role of central banks in addressing them within their financial stability mandate. It does so by developing a three-layered analytical framework that central banks could use to shape their climate-related monetary and financial policies. First, central banks have already started to revisit their backward-looking risk models for the purpose of integrating forward-looking climate-related risks. Second, given the limitations of existing climate-economy models in a context of radical uncertainty, we argue that future climate scenario analysis should rely on systems-based approaches such as non-equilibrium models and more qualitative tools such as those provided by a socio-technical perspective. However, even these new approaches will not suffice from the perspective of financial stability: climate-related risks will remain largely unhedgeable as long as a system-wide and structural transformation is not undertaken, including an unprecedented level of cooperation between central banks, fiscal authorities, the private and public sectors at large, civil society, and the international community. Third, and as a result of the first two points, embracing climate-related uncertainty means that central banks play a new role: helping to coordinate the policies needed to fight climate change, so as to fulfil their own mandate of financial stability. To this end, we make a few specific policy proposals. Key policy insights Central banks’ traditional risk models do not enable them to identify climate-related systemic risks (Green Swans). Adopting new forward-looking and non-equilibrium modelling approaches is necessary to better appreciate the nature of climate-related risks, but it is not sufficient. To continue fulfilling their mandate of financial stability over longer time horizons than those traditionally considered, central banks must also get involved in policy coordination to mitigate climate change. This includes exploring which policy mixes (fiscal-monetary-prudential) can better address the climate imperatives ahead; considering climate stability as a global public good to be supported through reforms of the international monetary and financial system; and systematizing the integration of long-term sustainability criteria in both private and public sectors.