Climate change, financial instability and central banking

Abstract

This chapter, contributed by Giada Valsangiacomo, presents the salient impacts of climate change on financial stability and discusses the role that central banks can play in addressing the resulting issues. After an overview of the commonly acknowledged features of the climate emergency, a brief illustration of climate-related risks together with transmission channels linking those risks to the financial system is outlined. The chapter will also show how the ensuing menace to financial stability, of which a new operational definition is given, provides scope for central banks to act without jeopardizing their existing mandates. To be read as a critique of mainstream analysis, the analysis also points out how radical uncertainty, as defined by Frank H. Knight a century ago, is a factor that utterly reshapes the analytical framework and thus the range of potential central bank responses. The latter should focus not only on merely upgrading macroprudential policies, but more importantly on implementing precautionary measures, which would ultimately improve financial market resilience to climate-related risks. Most notably, this new financial stability framework would impart clear guidance to the greening of financial markets and momentum for an orderly transition to a carbon-neutral economy. Despite the valuable promise of these measures, strong evidence persists that central bank action would need to be supported by a more comprehensive set of economic policies, in order to effectively overcome both climate and financial instability.