Stress testing framework quantifies nature physical risks for banks and insurers
De Nederlandsche Bank researchers present a top-down stress testing framework to quantify the financial stability impact of nature degradation, focusing on water-related risks for banks and insurers. The methodology links nature, the economy, and the financial sector to estimate credit and market risk losses.
Mapping nature shocks to financial losses
This paper introduces a top-down stress testing framework designed to estimate the financial stability impact of nature degradation, specifically focusing on water-related risks.
The methodology coherently links nature, the economy, and the financial sector, aligning with the NGFS conceptual framework.
Researchers modify the Merton model to account for companies' vulnerability to nature shocks, translating these into higher probabilities of default.
This, in turn, drives credit and market risk losses for banks and insurers.
The framework delivers granular indicators, from sectoral production impacts to market revaluations and prudential ratios, supporting diverse analytical and supervisory applications.
Losses are allocated based on sectoral, geographical, and ecosystem-service vulnerabilities, providing a comprehensive view of risk distribution.
The rising tide of nature-related financial risks
The central banking community increasingly recognizes that nature-related risks, including biodiversity loss, pose a significant threat to financial stability.
Institutions like the NGFS, ECB, DNB, and FSB have highlighted the macroeconomic implications of nature degradation and voiced supervisory expectations.
This recognition follows seminal work, such as the IPBES Global Assessment Report and the Dasgupta review, which documented widespread nature degradation and the economy's dependence on ecosystem services.
Nature-related financial risks are categorized into physical risks (from degradation) and transition risks (from misalignment with protective actions).
While initial assessments focused on 'exposure-based' dependencies, a gap remains in translating a nature shock into a quantifiable financial stability impact, a void this paper aims to address.
Filling a critical methodological void
This DNB working paper provides a crucial methodological advancement by offering a coherent framework to quantify nature-related financial risks, moving beyond qualitative assessments.
While the reliance on proxy macroeconomic scenarios and a 10 percent GDP loss benchmark is a necessary simplification, it enables a tangible estimation of financial stability implications.
This work is a vital step towards integrating complex ecological factors into prudential supervision, despite the inherent data challenges and the need for further refinement of nature-to-economy models.