Climate

Stress-test
of the Financial System

Stefano Ba*ston,
FINEXUS Center for financial networks and sustainability,
Dept. of Banking and Finance, Univ. of Zurich
2
 Outline

•  Network analysis of direct and indirect exposures

•  Disclosure of climate-relevant financial informaFon is key to

improve risk esFmaFons and create the right incenFves for
investors. However, beHer disclosure may not be sufficient.

•  The Fming and credibility of the implementaFon of climate

policies maHer.
•  Early and stable policy framework: smooth carbon-asset
values adjustments
•  a late and abrupt implementaFon: adverse systemic
consequences for the financial system.

(1) BaSston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., VisenFn, G.: A Climate stress-test of the
EU financial system. Available SSRN id=2726076. (2016).
 The Source of Complexity in the Climate – Finance nexus

Shocks on
financial
Climate exposures Systemic risk,
Change inequality

Climate
Relevant Financial
Sectors Sectors

Climate Shocks on Financial

Policies Financial Regulation
provisions
 Dashboards

•  Dashboard on EuroArea network-based stress-test
hHps://simpolproject.eu/2016/06/09/debtrank-2/ [BaSston et al 2016,
Leveraging the network. StaFsFcs and Risk Modeling, 1–33].
•  Dashboard Climate Stress-test financial
hHps://simpolproject.eu/2016/06/10/climate-stress-test/ [BaSston et al.
2016, A Climate stress-test of the financial system. Available at SSRN
id=2726076.].
Loan Porgolios of Major Euro Area Banks – Leverage across sectors

6
7
 The NO-CONTAGION Paradox
TradiFonal systemic risk model predict liHle contagion, because two key
assumpFons rule out contagion by construcFon
1.  R =1 i.e. banks assets can be liquidated at any Fme with no loss
2.  Only default valua=on: obligaFon’s value unaffected by losses on
obligor’s equity unless default.
Conserva=on constraint on losses in the process.
à network structure is irrelevant for the aggregate losses.
à Almost no banks’ defaults ajer iniFal defaults

In a distress contagion accounFng framework, intra-financial contagion

approximated by simple and instrucFve formula
H = ε s + (1-RE) β ε s = 2 ε s
where H is the relaFve equity loss in the banking system, b is the interbank
leverage, e is the external asset leverage, and RE is the recovery rate on
external assets.

(1) VisenFn et al. 2016 “Rethinking Financial Contagion”,

(2) BaSston, Caldarelli, D’errico, Gurciullo, S. (2016). Leveraging the network. StaFsFcs and Risk Modeling, 1–33.
BaSston, S., Roukny, T., SFglitz, J., Caldarelli, G. & May, R. The Price of Complexity in Financial Networks. PNAS
(2016) www.pnas.org/content/113/36/10031.full
FINEXUS climate stress test methodology
² New framework based on network analysis to assess the
largest exposures of financial actors to climate policy risks
² 3 key conceptual/methodological innovaFons:
1.  Reclassifica=on of NACERev2 sectors
2.  QuanFficaFon of direct exposure through external assets
3.  Assessment of indirect exposure, including intra-financial
interlinkages
DATASETS:
•  Bvd Orbis and Bankscope
•  ECB Data Warehouse
•  NACE code descripFon
Ba#ston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., Visen.n, G.: A Climate stress-test of the
financial system. Available SSRN id=2726076. (2016).
Some indirect exposures of financial sectors to the real economy

13%

Gov Non-MMF IF 30%

I&PF
(Government) 9% (Non-MMF (Insurance&

Investment funds) Pension funds)
Total assets: 5T

Total assets: 10.3T Total assets: 9.3T

15%
HH
(Households)
5% OFI
Total assets: 22T
(Other Financial
16%
InsFtuFons)

Total assets: 26.8T

NFC 5% 6%
(Non-financial
corporaFons) Banks
(MFIs)
Total assets: 21T 12% Equity holdings

Total assets: 31 T Bond holdings

Equity=A-L: 3 T 24% Loans holdings
NB!: NormalizaFon for all actors – by the total assets
 Financial exposures
IF
(Non-MMF
Gov Investment funds)
I&PF

(Government) Total assets: 10.3T

Total assets: 5T (Insurance&

Pension funds)

Total assets: 9.3T

NFC
(Non-financial OFI
corporaFons) (Other
Financial
Total assets: 21T InsFtuFons)

Total assets:
26.8T

Banks
(MFIs)
HH
Total assets: 31 T
(Households) Equity=A-L: 3 T

Total assets: 22T
Macro-economic
feedback
Methods: iden=fica=on of the climate
sensi=ve sectors
U/li/es

Fossil-fuel Energy-intensive
extrax/on Fossil-fuel
supply
sector Electricity
supply
Electricity
supply Transport
Reclassifica.on logic:

1. U/li/es, transport, housing -

top sectors for GHG emissions
(scope 1)
Housing 2. Fossil-fuels (low direct but high
indirect emissions)
3. Ac/vi/es affected by climate
Main channels:
policy either through costs or
1. Fossil-Fuel->U/li/es->Transport revenues).
2. Fossil-Fuel->Transport
3. U/li/es->Housing
4.U/li/es->Energy-intensive

Figure 1. Diagram illustraFng the reclassificaFon of sectors from NACE Rev2 codes
into climate relevant sectors.
Methods: iden=fica=on of direct&indirect exposures to
the the climate sensi=ve sectors

Direct exposures: through assets of the market player

S - Set of climate-relevant sectors
⎛ ⎞ Ai - Total assets of the financial actor i
Ai = ⎜⎜ ∑ ∑α
Equity Bonds
ij
Loans
+ α ij + α ij ⎟⎟ + Ri
⎝ S∈S j∈S ⎠ αij - Monetary value of exposure of i to j
AFS = ∑α iS - Exposure of insFtuFon F to
i∈F a given climate sector

Indirect exposures: through interlinckages of the market

player with its couterparFes
⎛ ⎞ ⎛ ⎞
Ai = ⎜⎜ ∑ α ij (A j ) + α ij (A j ) + α ij (A j )⎟⎟ + ⎜ ∑ α ik + α ik + α ik ⎟ + Ri
Equity Bonds Loans Equity Bonds Loans

⎝ j∈F ⎠ ⎝ k∈A/F ⎠

αij0 ⋅ α 0jk - Product of exposures along the chain

 Methods: iden=fica=on of the climate sensi=ve sectors
Reclassifica,on of economic sectors Classifica,on of assets according to
from NACE2 into climate-sensi,ve instrument and climate-sensi,ve
sectors sectors

Climate-sensi,ve Asset PorBolio Asset PorBolio by

NACE2 codes sectors climate sector
by instrument
B Fossil-fuel
Equity
U,li,es
C
Bonds
Energy-
intensive
D
Loans
Housing
F

H Transport

TradiFonal Proposed

Ba#ston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., Visen.n, G.: A Climate stress-test of the EU
financial system. Available SSRN id=2726076. (2016).
Results: Exposure to climate sensi=ve sectors

Equity holdings in EU and US listed companies. Sector composiFon of aggregate

insFtuFonal sectors world-wide according to BvD data 2015.
Ba#ston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., Visen.n, G.: A Climate stress-test of the EU
financial system. Available SSRN id=2726076. (2016).
 PorYolio composi=on of top world-wide Investment Funds:
climate-sensi=ve sectors exposure

u  This micro-level approach allows us to understand heterogeneity of investors’

exposure and porgolio allocaFon.

Ba#ston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., Visen.n, G.: A Climate stress-test of the EU
financial system. Available SSRN id=2726076. (2016).
 PorYolio composi=on of top world-wide Banks:
climate-sensi=ve sectors exposure

u  This micro-level approach allows us to understand heterogeneity of investors’

exposure and porgolio allocaFon.

Ba#ston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., Visen.n, G.: A Climate stress-test of the EU
financial system. Available SSRN id=2726076. (2016).
Rela=ve porYolio composi=on of top world-
wide Banks: climate-sensi=ve sectors exposure

Ba#ston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., Visen.n, G.: A Climate stress-test of the EU
financial system. Available SSRN id=2726076. (2016).
 Exercise 1. Upper bound of Euro Area banks’ loss:
100% shock on Fossil-Fuel+U=li=es sector

Impact on the top 50 listed EU banks of a 100% shock in the market capitalizaFon of
the climate-sensiFve sectors in different, progressive aggregaFons.

•  Equity loss of EU banks from a fossil-fuel sector shock only is 2.55%, and increases to
6.08% when including indirect effects.
•  Losses increase to 13.18% (direct effect) and 27.91% (direct and indirect effect) when
including uFliFes and energy-intensive industries on equity shares (1.2 T).
Exercise 2. Shocks obtained from LIMITS IAM database
Exercise 2. Shocks obtained from LIMITS IAM database

First round losses (top) and

second round losses (boHom)
of a “brown” and “green”
banks’ equity

Exercise 2. Shocks obtained from LIMITS IAM database

Value at Risk (5% significance) for

the 20 most affected EU banks in
the dataset, under the scenario of
g r e e n ( b r o w n ) i n v e s t m e n t
strategy.

Darker colors: VaR(5%) in the
distribuFon of first-round losses.
Lighter colors: VaR(5%) in the
distribuFon of first- and second -
round losses together.

 The Source of Complexity in the Climate – Finance nexus

Shocks on
financial
Climate exposures Systemic risk,
Change inequality

Climate
Relevant Financial
Sectors Sectors

Climate Shocks on Financial

Policies Financial Regulation
provisions
 Conclusion

•  Financial interconnectedness maHers for financial stability
and macro-prudenFal policy.
•  In the presence of uncertainty on value of assets backing
up obligaFons, and uncertainty on default resolu=on
process, direct losses from shocks can be doubled, due to
indirect losses via intra-financial complexity1.
•  Further, inaccuracy on price of (systemic) risk increases
with complexity2.
•  CollecFve moral hazard: the financial system does not pay
for the

(1) BaSston, S., Puliga, M., Kaushik, R., Tasca, P., & Caldarelli, G. (2012). DebtRank: Too Central to Fail? Financial
Networks, the FED and Systemic Risk. ScienQfic Reports, 2, 1–6. BaSston, Caldarelli, D’errico, Gurciullo, S. (2016).
Leveraging the network. StaFsFcs and Risk Modeling, 1–33.

(2) BaSston, S., Roukny, T., SFglitz, J., Caldarelli, G. & May, R. The Price of Complexity in Financial Networks. PNAS
(2016) www.pnas.org/content/113/36/10031.full
 Conclusions

•  Climate policies as potenFal source of (endogenous) shocks to

the financial system.

•  TradiFonal cost-benefit analyses: aggregate esFmates not

adequate to idenFfy individual risks and their propagaFon
through the financial system.

•  Network analysis of financial dependencies: direct and

indirect exposures to climate-policy relevant sectors
represent a large por=on of investors’ porYolios – in
parFcular for investment funds and pension funds.
 Conclusions

Findings of our study1 suggest that:

•  Disclosure of climate-relevant financial informa=on is key to
improve risk esFmaFons and create the right incenFves for
investors. However, beHer disclosure may not be sufficient.

•  The =ming and credibility of the implementaFon of climate

policies maHer. An early and stable policy framework would
allow for smooth carbon-asset values adjustments and lead to
potenFal net winners and losers.

•  In contrast, a late and abrupt policy implementaFon would

have adverse systemic consequences for the financial system.

(1) BaSston, S., Mandel, Antoine, Monasterolo, I., Schuetze, F., VisenFn, G.: A Climate stress-test of the
financial system. Available SSRN id=2726076. (2016).