Misleading economic models increase the risk of a climate financial crisis

The models used by economic authorities to quantify the financial impact of climate change give financial markets a false sense of security. By understating climate risk, they allow delayed action, which fuels the build-up of systemic risk and increases the likelihood of a climate-driven financial crisis.

Misled into the storm by “overly-sunny” economic forecasts
Imagine a massive ocean liner – the global financial system – preparing to cross an ocean. The weather forecast predicts a bit of choppy water, but nothing the ship can’t handle. However, there is a hidden problem: the computer model used to create that forecast only looks at past storms. It is physically incapable of seeing the “Green Swans” – the hurricanes that scientists warn are building just over the horizon.

Even as scientists repeat that the current direction of travel leads the ship into a storm much bigger than it can handle, the forecast remains “benign”. Economists are hard at work to improve forecasting tools but by the time the forecasts are robust enough (and economic models reliably reflect climate science), the ship will have advanced too far into the storm (the build-up of climate risk across the financial system will have far exceeded its capacity to withstand a “climate Minsky moment”). The only way to save the ship is to avoid the eye of the storm in the first place with an early – preventive – change of course.

Financial markets on course for a hurricane
Climate change is already an imminent danger for the financial system. In the next five years, extreme weather events could put up to 5% of the euro area’s economic output at risk. In just 25 years, climate risk could cost the global economy $23tn annually, slashing global economic growth by between 11% to 14% according to estimates by global insurer Swiss Re. A report by the Institute and Faculty of Actuaries (among the most conservative and data-driven financial professionals in the world) predicted that the global economy could face a 50% loss in GDP between 2070 and 2090 from catastrophic climate shocks, far higher than previously estimated.

And these figures are conservative, based on economic models which are unadapted to reflect the phenomenon of climate change. At odds with climate science, these models fail to account for tipping points, rising sea levels, compound risks, system-wide amplification effects and the disruptions that will emerge from the materialisation of societal risk, such as climate-related conflict and mass migration. The truth is: the financial system’s real exposure to climate risk is still largely unknown.

What is a “climate-driven financial crisis”?
What is known is this: the “climate scenarios” used by prudential authorities to model the impact of climate risk on financial institutions (the “weather forecasts”) understate the effects of climate change by a large margin. Central banks recognise this, while a report drawing on a survey of 68 climate scientists, confirms it. Massive financial damage can materialise suddenly, and financial institutions are not ready for it.

The last time that a significant amount of hidden risk suddenly materialised (the subprime crisis in 2008), it ended up costing Europe a decade of growth and trillions in taxpayers’ money – which citizens are still paying for. And the financial system is still vulnerable.

The 2008 post-crisis “never again” financial reform agenda has been significantly watered down while some of the risk has been transferred to the under-regulated shadow banking sector. Recently, a relatively small shock triggered the 2023 banking crisis in the US resulting in several bankruptcies in the American banking sector which forced the Federal Reserve to intervene massively. The sudden fall of the banking giant Credit Suisse (whose solvency ratios and liquidity ratios were substantially above what current regulations require) was another recent warning shot.

In this context, prudential authorities already consider the fast growth of unaccounted climate risk as a potential trigger for the next big financial crisis – a “climate financial crisis”.

Flawed modeling: why the “forecast” is wrong
Current economic models used by banks and regulators have several structural limits that act like a faulty weather station:

Using historical data: Most models rely on historical data to predict future risks. But climate change is a forward-looking, unprecedented event; past economic data cannot predict a world where more than 3 billion people will have to adapt to progressively uninhabitable living conditions.
The “equilibrium” hypothesis: These models treat the economy like a boat that will always right itself, or return to a “stable equilibrium” after a shock – damage may be costly but the vessel will remain seaworthy. In reality, climate tipping points are irreversible shifts that can inflict permanent damage on the “ship” we are in.
Mathematical shortcuts: Many models use a quadratic function, a math formula that assumes damages grow slowly and predictably. This ignores the non-linear reality of climate change, where a small temperature rise can trigger a sudden, massive jump in economic destruction.
Ignoring the “big hits”: Many models simply exclude hard-to-quantify drivers like mass migration, sea-level rise, and conflict. This is like a weather forecast that ignores hurricanes because they are “too difficult to model”.
A false sense of security
Because of these flaws, current models predict only “benign” economic losses, even at catastrophic levels of warming. Some models even suggest that a 6°C increase – a level scientists say could end human civilisation – would only result in a small 10% dip in GDP (!).

This underestimation of risk means that banks and insurers are not building up enough capital buffers (which increase their loss absorption capacity) to survive the losses looming on the horizon. Waiting for the “perfect data” to show the crash is happening means it is already too late to stop it.

Don’t wait for the ship to sink: navigate with precaution
In this context, navigating with a “precautionary approach” means acting now based on the certainty of the direction of travel, even if the exact timing of the waves cannot be quantified. We don’t need a perfect model to know we need to stay away from the eye of the storm.

Immediate steps for a more prudent journey include:

Using qualitative scenarios: Supervisors should complement quantitative metrics with evidence-based judgment from climate science that accounts for tipping points and potential breaking points for the financial system.
Raising capital requirements: Regulators should require banks and insurers to strengthen their loss absorption capacities to address climate risk. This “cushion” would prevent a climate crisis from leading to another taxpayer bailout.
Preventing the risk from growing: With the radical uncertainty of climate change and the difficulties in modelling its financial impact, supervisors should take measures to prevent the rise of climate risk through targeted macroprudential measures.
Without a full picture of the losses that climate change could cause, the financial system is sailing blind. Supervisors cannot allow flawed economic models to provide an alibi for inaction. By adopting precautionary measures today, financial authorities can ensure the financial system is resilient enough to weather the coming storm and can support the economy in troubled times.