2019/42 LEM Working Paper Series

The public costs of climate-induced financial instability

Francesco Lamperti, Valentina Bosetti, Andrea Roventini and Massimo Tavoni
Climate Change; Climate Impacts; Financial Crises; Public Debt; Macroprudential Policy.

  JEL Classifications
C63, Q40, Q50, Q54
Recent evidence suggests that climate change will significantly affect macro-economic growth and several productive elements of modern economies, such as workers and land [Dell et al., 2009, Burke et al., 2015, Carleton and Hsiang, 2016]. Although historical records indicate that economic shocks lead to financial instability, few studies have focused on the impacts of climate change on the financial system [Dietz et al., 2016, Dafermos et al., 2018]. This paper evaluates a global economy where multiple banks provide credit to production activities exposed to climate damages. We use an agent based climate-macroeconomic model calibrated on stylized facts, future scenarios and climate impact functions [Nordhaus, 2017] affecting labour and capital. Results indicate that climate change will increase the frequency of banking crises (+26-148%). The public costs of rescuing insolvent banks will cause an additional burden of about 5-to-15% of GDP per year, and an increase of public debt to GDP by a factor of 2. We estimate that around 20% of such effects are caused by the deterioration of banks’ balance-sheets. Macroprudential regulation attenuates bailout costs, but only moderately. Our results show that leaving out the financial system from climate-economy integrated assessment may lead to an underestimation of climate impacts, and that financial regulation can play a role in mitigating them.
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