A macroprudential approach to compound climate risks

Climate change is often characterised as a standalone risk for the financial system. In practice, however, the emergence and materialisation of climate-related shocks interact with general macro-financial conditions, implying potentially novel and difficult-to-predict interactions. In such an environment, macroprudential buffers earmarked for specific risks have limitations, as they might not account for important correlations between climate-related shocks and other sources of financial vulnerability, nor for the extent to which climate-related shocks might compound existing challenges in the real economy and financial sector. In light of such complex challenges, this report investigates how a holistic approach can enhance the financial system’s ability to absorb compound shocks. It finds that consolidated capital buffers accounting for the amplifying effects of combined shocks, which single-risk buffers might underestimate, offer general insurance against several sources of uncertainty (both reducible and irreducible).