Waller Offers Common Sense View on Financial Risks of Climate Change

At a recent conference in Spain, Federal Reserve Board Governor Christopher Waller said the risks associated with climate change do not represent a unique threat to the stability of the United States financial system. As such, he sees no need for the Fed to adopt special regulations to mitigate climate-related risks, especially when doing so may divert the Fed’s attention away from other, more relevant risks.

Financial instability occurs when lenders do not get paid back or fear they may not. When this happens, lending falls and interest rates rise, reducing credit availability and harming the broader economy. If lenders lack the resources necessary to absorb the losses they incur when borrowers default on their loans, they may be unable to pay back their depositors. If left unchecked, this dynamic can quickly lead to a financial crisis.

Governor Waller noted that a financial stability risk must possess two features. First, it must have near-term effects, likely resulting in lenders not being paid back. If the effects of the risk are a long way off, lenders can hedge against the risk by pricing it into their contracts with borrowers—in which case, the risk would not pose a threat to financial stability. Second, a financial stability risk must be serious enough that it could result in sufficiently large losses that threaten the entire economy, not just a handful of financial institutions. These two features allow the Fed to make a distinction between unpredictable economic shocks and vulnerabilities in the financial system (e.g. overvalued assets, liquidity risk, and the amount of debt held by households and businesses) that can be dealt with via policy.

Governor Waller argues that the Fed can promote a resilient financial system robust to various potential shocks by focusing on these vulnerabilities. In his view, this approach is superior to preparing for specific shocks that may or may not happen because it does not require policymakers to possess the knowledge necessary to identify the probabilities of each and every potential shock to the financial system.

What does all this have to do with climate change and its risks to financial stability? Governor Waller explains that we can sort climate-related financial risks into two groups. The first are physical risks, such as more frequent or severe weather events like hurricanes. These risks can affect financial stability by lowering property values. Financial institutions that lend against these types of assets could become less sound, resulting in their curtailing their lending and thus reducing economic growth. Another possibility is that property values could fall simultaneously if the insurance companies insuring these properties leave a particular region due to climate change’s physical risks.

In Governor Waller’s view, neither of these possibilities uniquely threatens the financial system. He points to research suggesting that property losses caused by extreme weather events do not significantly affect the stability of the financial system. He also cites research suggesting that lenders are already pricing in the physical risks of climate change. Finally, he notes that financial institutions have more than enough capital to absorb the losses that these physical risks could cause.

The second type of risk associated with climate change that Governor Waller points to is the risk associated with moving to an economy that produces fewer greenhouse emissions. Since this transition will likely be relatively predictable and gradual, lenders and borrowers should not have trouble pricing transition costs into their agreements. But even if the transition is chaotic — due to policy uncertainty or technological innovation, for example — it would not pose a unique threat to financial stability. 

As Governor Waller notes, policymaking often involves a lot of uncertainty, but historically this uncertainty has not been a source of financial fragility. Likewise, climate-related innovation is no different from other forms of innovation in that both can be “disruptive.” Hence, climate-related innovation does not seem to pose a unique risk to the financial system. And lenders have a long history of adapting to technological innovation.

Governor Waller’s common sense view on the financial risks of climate change is noteworthy and commendable. His remarks signal a willingness of Fed officials to push back on calls by politicians and pundits for the Fed to get more involved in ideologically charged debates that threaten to undermine the central bank’s independence, especially during a time when the Fed is trying to lower historically high inflation. Focusing on specific risks, like climate change-related ones, necessarily involve value judgments. Such value judgments should be left to politicians, not the unelected regulators at the Fed.

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This article, Waller Offers Common Sense View on Financial Risks of Climate Change, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.

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