[The Economics of Heatwaves⑦] "Climate Risk Causes Financial Crises"... Scorching Heat Topples Banks

[Asia Economy Reporter Song Seung-seop] Heat does not only damage the human body. Heatwaves also disrupt finance. The hotter the Earth becomes, the more precarious banks get. It may sound far-fetched, but major financial institutions around the world have already begun preparing for the shocks that global warming will inflict on the financial system. Even major investors in the investment industry, who previously paid no attention to climate issues, are now keenly focused on climate change. This is because there is a growing awareness that crises triggered by climate are unpredictable and cause severe, irreversible damage. 'The Economics of Heatwaves'

The most direct impact of the climate crisis on the financial system is inflation. When heatwaves and extreme heat reduce crop yields and cause food prices to soar, inflation rises. This phenomenon is called ‘agflation.’ Even when the economy is weak, prices skyrocket, and central banks aggressively raise benchmark interest rates, but inflation does not subside. This is why central banks, which are responsible for managing inflation, pay particular attention to the climate crisis.

Accordingly, in developed countries, central banks that were once inflation fighters are transforming into ‘crisis fighters’ to prevent climate change. The European Central Bank stated, “Considering the impact of climate change on prices, it is necessary to respond to the transition to a low-carbon economy,” and the Swedish central bank declared, “Climate risks have serious effects on the economy,” adding, “Preventing this is also a goal of monetary policy.”

Private banks also suffer losses. As interest rates rise, borrowers struggle to repay loans, and banks that provided the funds inevitably face losses. Moreover, heatwaves change not only prices but also various policies, society, and customer perceptions. The value of coal-fired power assets, which banks still hold in large amounts, plummets, and related project financing (PF) loans may become completely impossible. The rapid transition to a low-carbon economy inevitably increases market imperfections. As natural disasters become more frequent, insurance companies are also likely to face greater losses.

On the 25th, when heatwave warnings were issued for most regions nationwide, mirages caused by ground heat were rising at the Sejongno intersection in Jongno-gu, Seoul. Photo by Jinhyung Kang aymsdream@

The theory linking climate change and financial crises was first ignited in 2020 by the Bank for International Settlements (BIS). BIS was the first to propose the capital adequacy ratio used globally by banks. At that time, BIS released a report titled ‘The Green Swan: Central Banking and Financial Stability in the Age of Climate Change.’ The economic term ‘Green Swan’ first appeared in this report.

BIS explained the difference between Black Swan and Green Swan as follows. Humanity believed all swans were white until black swans were discovered in Australia in 1967, causing a stir. Thus, a ‘low-probability but high-impact crisis’ has been commonly called a Black Swan. In contrast, a Green Swan arises from environmental factors. It refers to risks caused by various natural disasters triggered by the climate crisis.

The commonality between Green Swan and Black Swan is ‘unpredictability.’ The climate crisis cannot be predicted in terms of when and how it will occur based on past accumulated data. Traditional preparedness measures currently in place at financial institutions and banks may not be effective. The difference lies in ‘shock and irreversibility.’ BIS warns that Green Swans could cause more severe situations than any financial crises experienced so far. Unlike Black Swans, overcoming or escaping a financial crisis caused by a Green Swan is practically impossible.

The Network for Greening the Financial System (NGFS), which the Financial Services Commission and Financial Supervisory Service joined as members last year, even proposed the role of financial authorities in preventing the climate crisis. NGFS is a green finance network of global financial supervisors led by the G20 (Group of Twenty). NGFS pointed out, “Climate risk is the root of financial risk,” and “The crisis caused by climate change is a source of financial risk, and it is the authority of central banks and supervisors to verify how financial institutions respond to these risks.”

The International Monetary Fund (IMF) expressed a similar view. The IMF stated, “Private financial institutions underestimate climate change risks,” warning that this could cause an imbalance in the allocation of financial resources. It also analyzed that “central banks need to respond to climate change risks through changes in loan collateral systems and asset purchase compositions.” This means central banks must ensure that their domestic banks, insurance companies, and securities firms are well prepared for the climate crisis.

According to the Bank of Korea’s December report last year titled ‘Climate Change Transition Risk and Financial Stability,’ intense climate policies (limiting global temperature rise to 1.5°C) increase the default rate of high-carbon industries by 0.63 percentage points. In particular, domestic banks hold many assets related to high-carbon industries, and their capital adequacy ratios are projected to plunge by 2.6 to 5.8% by 2050. The report predicts that bank soundness will sharply deteriorate in 2040, when greenhouse gas reduction costs rise rapidly.

The problem is that if carbon neutrality policies are not implemented swiftly, the Korean economy, centered on banks, will suffer greater damage. The report suggests, “If banks do not proactively respond to transition risks, defaults will occur in vulnerable assets, leading to significant losses,” and forecasts, “If financial institutions establish risk management systems that consider climate change factors and promote ESG (Environmental, Social, and Governance) investments to reduce holdings of assets vulnerable to transition risks, the scale of shocks will be significantly reduced.”

Reporter Song Seung-seop tmdtjq8506@