Non-banks contagion and the uneven mitigation of climate risk

Abstract

This paper develops a framework for the short-term modelling of market risk and shock propagation in the investment funds sector, including bi-layer contagion effects through funds’ cross-holdings and overlapping exposures. Our work tackles chiefly climate risk, with a first-of-its-kind dual view of transition and physical climate risk exposures at the fund level. So far, while fund managers communicate more aggressively about their awareness of climate risk, it is still poorly assessed. Our analysis shows that the topology of the fund network matters and that both contagion channels are critical in its study. A stress test based on granular short-term transition shocks suggests that the differentiated integration of sustainability information by funds has made network amplification less likely, although first-round losses can be material. On the other hand, there is room for fund managers and regulators to consider physical risk better, and mitigate the second-round effects it induces, as these are less efficiently absorbed by investment funds. Improving transparency and setting relevant industry standards in this context would help mitigate short-term financial stability risks.