Climate, ECB analysts: “Transition risk a danger to financial stability”

Brussels – Climate and transition efforts pose a risk to financial stability. Through a new study dedicated to the topic, the European Central Bank once again highlights the interrelationship between climate change, systemic risks, and banking liquidity. In a nutshell, the situation is that “the transition risk increases firms’ production costs and exerts downward pressure on profits, increasing the risk of default. As a consequence, banks lending to these firms face a higher credit risk.” 

In essence, it is the classic vicious circle: those who borrow for riskier activities expose themselves to the risk of bankruptcy, while lenders, in turn, expose themselves to liquidity crises. A self-feeding phenomenon. The ECB’s analysts, however, want to be clear about the need to address global warming, with all that it entails, in an effective and timely manner. Climate change, they point out, “can increase market risk through multiple channels, potentially depressing real estate and corporate values, reducing corporate profits and eroding household wealth.” These effects, in turn, “can exacerbate credit, market, and liquidity risks throughout the financial system.” 

Corrective actions are needed. It will be up to politicians to find the solutions, certainly not the Eurotower’s experts, who, in any case, identify critical issues. Meanwhile, it is pointed out that in lending, “the transition risk premium intensifies during periods of financial stress, indicating that climate-induced risks amplify existing vulnerabilities in financial markets.” Moreover, the results of the case analysis suggest that transition risk may amplify other exogenous financial risks. As they point out, “although transition risk alone may not induce immediate stress in the secured lending market, its mere presence implies that banks are subject to differential treatment in terms of funding costs. This dynamic suggests that, “in the presence of significant market shocks, such amplification could actually exacerbate wider financial instability.”