Module 3: Systemic Risks

The Financial System

The financial system is comprised of banks, insurance companies, stock exchanges along with the various financial instruments they use. They play a critical role in the economy by facilitating exchange of funds between various participants to enable activities such as saving and borrowing, investing, and risk sharing. By lending out savings to those who can make productive use of it, banks enable a substantial amount of economic activity that would not otherwise occur. Likewise, by managing risk, insurers provide a more stable environment for investment.

When issues or crises arise in the financial system, liquidity problems can occur that may result in a reduction of access to personal or corporate credit. That has an effect on the “real” economy, undermining consumer and corporate demand by, for example, decreasing debt-financed consumption and capital investment.

The climate crisis can impact the financial system through both physical and transition risks, but also from feedback loops that can amplify the effect of an initial shock, leading to economy-wide effects.

For example, borrowers may suffer losses to their assets through exposure to physical or transition risks, which may undermine their capacity to service their debt obligations. Loan defaults increase, and banks reassess the loan-to-value ratio (ratio of the amount of a loan to the value of the assets against which the loan is secured) of their lending portfolio. To reduce their own risk exposure, banks pull back on their lending volume (e.g., by increasing their interest rates or changing their criteria for creditworthiness). With fewer loans issued, transactions that might otherwise contribute to the economy are forgone, due to a lack of debt capital to finance those activities. Economic activity slows further, potentially impacting other lenders and their capacity to repay their debt.

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Financial Impact of Climate Change Copyright © 2021 by Todd Thexton is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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