Missing the Boat

A “risk to the financial system” does not mean that someone, somewhere, someday, might lose money on an unwise investment.

Missing the Boat

Capital Thinking · Issue #993 · View online

In an October 21 press release, Janet Yellen — Treasury secretary and head of the Financial Stability Oversight Council (FSOC), the umbrella group that unites all U.S. financial regulators — eloquently summarized a vast program to implement climate policy via financial regulation:

“FSOC is recognizing that climate change is an emerging and increasing threat to U.S. financial stability. This report puts climate change squarely at the forefront of the agenda of its member agencies and is a critical first step forward in addressing the threat of climate change.”

You do not have to disagree with one iota of climate science — and I will not do so in this essay — to find this program outrageous, an affront to effective financial regulation, to effective climate policy, and to our system of government.

-John H. Cochrane

A convenient myth: Climate risk and the financial system

John H. Cochrane | The Grumpy Economist:

Of all the threats posed by a slowly warming climate, why is Ms. Yellen talking about financial stability?

The answer is simple: Financial regulators are not supposed to implement each administration’s policies on non-financial matters. Financial regulators may only act if they think financial stability is at risk.


Imagine that Trump returns. He declares, “Illegal immigration is an existential crisis. I can’t get Congress to do anything about it. Financial regulators: Tell banks to freeze the bank accounts of any customers who can’t prove legal status. Scour people’s accounts for payments to illegal employees. Freeze out any business that hires an illegal.”

You would be shocked. The nation would be shocked. Ms. Yellen would be shocked.

There is no financial risk here, we would all say. This is a vast abuse of power.

Financial regulation can only touch climate policy if there is a risk to the financial system that only coincidentally involves climate. But how could climate possibly pose a risk to the financial system?

A “risk to the financial system” does not mean that someone, somewhere, someday, might lose money on an unwise investment.

A risk to the financial system means an event like 2008: a shock so big, so pervasive, and so fueled by short-term debt that it sparks a widespread run, a wave of defaults, and threatens the ability of the whole system to function.

“Financial regulation” means looking at the assets and liabilities of financial institutions to mitigate such a risk. It can at best look a few years in the future.

So, if we use plain English, a “climate risk to the financial system” that “financial regulators” can contain must mean the climate might change so drastically, so abruptly, and so unexpectedly, in the next five years, that the economy tanks so terribly that financial institutions blow through the cushions of equity and long-term debt, to spark a widespread systemic crisis like 2008 or worse.

The trouble is, there is absolutely nothing in even the most extreme scientific speculations to support that possibility.

Climate is the probability distribution of weather: the chance of heat and cold waves, floods, fires, and so forth. We know with great precision what the climate will be for the next five years.

Nobody writing insurance in Florida is unaware of the chance of hurricanes. The chances of extreme weather are not going to change unexpectedly in even ten years.

The sea level is rising. It will continue to rise, about 4 millimeters per year – 2 cm in the next five years – slowly and predictably.

Risk is the unknown. This is known.

Moreover, even weather extremes just don’t move the economy that much. We have had many financial crises in history. Not one was sparked by an extreme weather event. Our modern, national economy is remarkably immune to weather.

It is simply not true that the economic damage of extreme weather events is either large or substantially increasing. Weather-related damages were 0.18 percent of global GDP in 2020. That’s tiny, and it’s decreasing, down from 0.26 percent in 1990.

The part of it that could be described as unexpected, threatening financial reserves, is tinier still. GDP fell 10 percent during the COVID recession. Unexpected climate risks would have to be 50 times larger in the next few years to approach that level of damage.

Even the most extreme weather events are local, a blip on the national economy and the assets of diversified banks.

In 1900, half a million people died in storms, floods, droughts, wildfires and extreme temperatures. By 2020, the number had declined to 14,000. So far, 5,500 people have died from climate-related disasters in 2021.

There are about 35,000 car crash deaths each year in the U.S. alone, and COVID has killed 750,000 Americans. Still, one could defend the effort.

Our financial regulators completely missed the possibility that mortgage-backed securities might bring down the financial system in 2008. Despite the army of Dodd-Frank regulators and stress-testers, regulators missed the possibility that a pandemic threatened to do the same in 2020. Only another massive round of bailouts saved us from another 2008.

The Fed went on to completely miss the chance that inflation might break out, while it orchestrated the printing of $3 trillion sent out to people as checks.

A dispassionate, honest effort to look at out-of-the-box risks to the financial system, together with a humble attitude towards regulators’ ability to foresee them, is a good idea.What might that effort find?

What if (when?) China invades Taiwan, and the U.S. and allies blockade China? A huge global recession.

What if the U.S. chooses to fight and loses? Greater catastrophe. What if the Middle East blows up, or a nuclear weapon goes off?

What if we have a real pandemic, one that kills 10 percent of the people it infects as plague, cholera, typhus, and tuberculosis did?

What if that pandemic comes out of a lab, this time deliberately? What about a massive financial cyberattack?

What if bond investors give up on U.S. Treasury debt and force a sovereign-debt crisis?

These are all unlikely. But the chance of any of these is thousands of times greater than the danger of climate change to the financial system.

And what should one do about such risks? Does it make sense for bank regulators and stress testers to demand that each bank rank the sensitivity of each loan it makes for its exposure to Chinese-invasion risk, and calibrate its portfolio accordingly?

Or, as is increasingly popular, to interact these risks and model general-equilibrium effects?

No.The response to out-of-the box unquantifiable risks is simply to demand that banks finance themselves with much more equity capital, which can absorb unforeseen losses without imperiling the bank and financial system.It is patently obvious that regulators did not evenhandedly open this Pandora’s box, or consider why, of all the risks to the financial system, climate change is the only one worth talking about.

Regulators want to tell banks to stop lending to fossil-fuel companies while, coincidentally, the political parts of the administration decided on the same climate policy.

And given their method, to regulate bank investments against “climate risks” that they cannot even define, rather than protect the system with equity (financial adaptation!), they are clearly not interested in actually protecting the financial system against unknowable catastrophes.

Pressed, advocates will quickly admit that’s not what they mean. Instead, they say, they worry about the risk of “stranded assets,” “transition risks,” losses in fossil fuel and other legacy industries.

Will environmental regulators, legislators, presidents, prime ministers, really fly back from Glasgow and pass laws and regulations so onerous that they tank the economy and financial system?

Well, they just might. But then at least one might be honest and call it “climate-policy risk!” But even this story does not pass muster.

Climate-policy advocates are turning to financial regulation precisely because presidents and legislatures, accountable to voters, are refusing to impose draconian carbon-killing policies.

It has some chutzpah, too: Carbon regulations might kill the fossil-fuel industry. So we have to… kill the fossil-fuel industry first.

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A convenient myth: Climate risk and the financial system