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Overlapping crises could fracture the global financial system

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The writer is a former senior vice-president at the World Bank

When the Titanic set sail in 1912, it was considered unsinkable because the hull was constructed as 16 watertight compartments. The ship would reportedly still float if up to four of these compartments were damaged. A similar assumption underpins today’s international financial architecture in the face of a polycrisis: runaway climate change, financial faultlines, the health pandemic, geopolitical dangers, the next generation of artificial intelligence and global water and food shortages.

International leadership seems to think that if two or more crises flare up simultaneously, the system will still float. This assumption is patently wrong. The interplay of the climate crisis with financial fragility alone threatens potentially insurmountable dangers unless immediate action is taken.

Global debt has hit unprecedented levels, weighing down a system still shaken by the pandemic. A shadow banking system of “non-bank financial intermediaries” emerged following the financial crisis of 2008, and now dominates about half of global financing. The unregulated financing attributable to NBFIs is about $240tn.

Meanwhile, the IMF and the World Bank struggle with their capacity to simultaneously tackle pandemic-induced deprivation and escalating climate change-triggered needs. Other risks, such as Russia’s war in Ukraine, add to the burden on the system. It is in this context that a worse-than-predicted climate crisis could bring the global financial system to its knees.

The 16 climatic tipping points, identified by a group of researchers in an article in Science, are triggers for a possible collapse in highly leveraged global financial markets. The markets, including regulators and central banks, have failed to integrate the physical, transition and liability risks from climate change into the observable market data.

Take one example: imagine if five of the largest property and casualty insurance companies and the three largest reinsurers failed following previously unlikely ice sheet melt and permafrost collapse, which would lead to flooding. The insurance companies would face unprecedented claims and a decimated investment portfolio, wiping out their capital bases.

Furthermore, the effects of climate change on food shortages and supply chain collapses would render the system even more fragile. Price levels would rocket due to a massive injection of liquidity in the global financial system, as a result of defensive actions such as central bank bailouts. Banks would be knocking on central bank doors to fend off the impact of insurance company defaults.

Taking global action now should be predicated on a recognition that the crisis that once seemed far in the future has arrived. Its reversal depends on an all-out effort to decarbonise economies.

This obliges the G20, a group that accounts for 80 per cent of the world’s gross domestic product, to take the lead in addressing the inherent fragility of the current architecture. Members must act swiftly to regulate key aspects relating to growing climate danger, including imposing bank capital charges for carbon-intensive activities.

Moreover, the G20 should impose a high enough carbon price to make it costly to use fossil fuels relative to clean energy sources, plus direct governments to reallocate the more than $5tn a year that they collectively provide in fossil fuel subsidies. These steps would help scale down atmospheric CO₂ towards 350 parts per million, which scientists consider a sustainable threshold.

In addition, regulators and central banks need to integrate liability risks stemming from climate change into market data. That means financial markets would need to ensure a lower cost of capital for securities with low climate change risk exposure or with strong mitigation promise.

Climate damages are translating into billions of dollars of unpriced losses globally, rendering shocks to a shaky system. To meet this challenge, the COP28 presidency ought to syndicate a $100bn adaptation fund among Opec countries. The proceeds would ease the immediate needs of the most vulnerable countries.

If markets included a public function rather than just the private, there would be no need for proactive intervention at the global level. But counting on the markets led to global financial crisis in 2008. That might seem minor compared with the financial peril that climate chaos may bring.

When divers reached the Titanic wreck on the ocean floor, they found the ship with its hull almost intact. Damage in one area had triggered its sinking. To avert a similar fate, the G20 must use its unique platform to act now.

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