How Does Climate Change Interact with the Financial System?

We survey the literature on the interaction between climate change, which is associated with the growing intensity and frequency of natural disasters, and the financial system. This paper focuses on three topics. First, we review whether prices of assets, such as real estate, stocks, and green bonds, incorporate climate risks. While many studies show that asset prices reflect climate risks to some extent, many others show that real estate properties, in particular, do not adequately reflect climate risks. Such mispricing may deter efforts to address climate change. Furthermore, investor behavior and asset prices can overreact when risks become more clearly recognized. However, disclosure may help alleviate mispricing and overreaction. Second, we discuss how natural disasters affect bank behavior. Credit demand increases in affected areas. However, credit supply, particularly from non-local banks to young and small firms, is suppressed even in unaffected areas, especially when banks have low capital ratios. Third, we consider the role of insurance and related challenges. Insurance facilitates risk sharing and often complements bank finance. There are, however, at least three challenges: increasing insurance coverage, particularly among low- income households and young and small firms, maintaining insurer solvency, and avoiding moral hazard.