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Climate Change Represents an Existential Threat to Financial Markets

Henry Darmstadter
Apr 08, 2021

Guidehouse Insights

Financial markets face many threats. Among these threats is climate change, which the Financial Stability Oversight Council (FSOC) publicly discussed on Wednesday, March 31. 

Climate Change, Financial Markets, and Oversight

Treasury Secretary Janet Yellen has been vocal about the threat climate change poses to the economy and financial markets since she was appointed. During the inaugural FSOC meeting in March, climate change was top of the agenda, underscoring its importance. Specifically, Secretary Yellen said climate change “poses a tremendous risk to our country’s financial stability. […] Our financial system must be prepared for the market and credit risks of these climate-related events.”

The FSOC was established in 2010 under Dodd-Frank and is responsible for monitoring the stability of the US financial system. This is the first time the FSOC has publicly discussed and acknowledged a need for a better understanding of the risks climate change presents the industry. Among the noted climate change risks at the inaugural meeting were a higher frequency and intensity in storms, as well as warming temperatures leading to disruption of food, water, and mass migration of people. These events can impact the value of financial assets around the world and pose a credit risk to financial institutions balance sheets. 

Heightened Climate Risk Awareness by All Financial Regulators

Beyond Treasury Secretary Yellen, other federal regulators including the Securities and Exchange Commission (SEC), Federal Reserve, and Federal Housing Finance Agency (FHFA) are heightening their focus on climate change-related risks. Specifically, each agency has announced their own unique initiatives to better understand climate risks as it relates to the specific markets and institutions they oversee. These include: 

  • SEC: President Biden’s nominee for SEC Chair, Gary Gensler, noted in his confirmation hearing that he would “support more climate risk disclosure” for public companies and undertake economic analysis to better understand the impact of requiring climate risk reporting. Public companies have historically not been required to report on exposure to climate risk and requiring them to do so entails added costs or regulations.     
  • Federal Reserve: Federal Chair Jerome Powell noted the Federal Reserve formed two committees tasked with overseeing climate risks as it relates to banks and health of the overall financial system. Financial institutions mortgage portfolios are especially vulnerable to climate risks related to storm frequency/intensity, chronic or sustained flooding, and warmer climates. The credit risk associated with a considerable or systemic drop in property values would send shock waves through financial markets.
  • FHFA: Director Mark Calabria is responsible for overseeing the Government Sponsored Enterprises (GSEs). Director Calabria recently hired two environmental economists to further bolster the FHFA’s ability to monitor the GSEs and report and forecast on climate risks as it relates to the overall mortgage market and their respective portfolios. GSE’s guarantee over 70% of the US housing market and so must be keenly aware of the risks climate change poses to the housing market and the underlying value of real estate.

Financial institutions must begin to identify, analyze, and understand their exposure to climate risks. Not only to protect themselves and shareholders, but also US financial systems.