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About this book

Today’s financial sector faces multiple challenges stemming from ecological, societal, and technological risks such as climate change, political extremism, and cyber-attacks. However, these non-traditional risks are yet to be fully identified and measured, in order to ensure their successful management. This edited collection sheds light on the topic by examining the unique measurement and modelling challenges associated with each of these risks, and their interaction with finance.

Offering a comprehensive analysis of non-traditional finance risks, the authors provide the basis for developing appropriate risk management techniques. With new approaches to protect against emerging threats to the financial sector, this edited collection will appeal to academics researching sustainability, development finance, and risk management, as well as policy-makers and practitioners within the banking sector.

Table of Contents


Chapter 1. Emerging Risks: An Overview

One of the core functions of financial institutions is risk management. Until recently, most institutions have focused on concepts such as cyclical variations in their business and the economy, their exposure to low and even negative interest rates, and the consequences of various other macroeconomic developments and internal decisions on their profit margins, solvency, and efficiency, among others. Our world is changing, and individuals and businesses are increasingly affected by factors that arise from outside the economy and the financial markets, yet display multiple interactions with the eco-financial system. Today—arguably more than ever—financial institutions face a variety of new challenges that require them to seriously rethink their risk management and investment practices. Climate change, mass migration, political extremism, trade wars, terrorism, cybersecurity threats, and the current evolution of financial technology (FinTech) are just some examples of ecological, societal, and technological factors that affect and interact with our financial markets. This book aims to highlight not only the threats but also the opportunities associated with these emerging risks, thereby providing an inspiration for academics, practitioners, and regulators who already work in or are interested in this field.
Thomas Walker, Dieter Gramlich, Kalima Vico, Adele Dumont-Bergeron

Ecological Risks


Chapter 2. Climate Change: Macroeconomic Impact and Implications for Monetary Policy

Climate change and policies to mitigate it could affect a central bank’s ability to meet its monetary stability objective. Climate change can affect the macroeconomy both through gradual warming and the associated climate changes (e.g. total seasonal rainfall and sea level increases) and through increased frequency, severity and correlation of extreme weather events (physical risks). Inflationary pressures might arise from a decline in the national and international supply of commodities or from productivity shocks caused by weather-related events such as droughts, floods, storms and sea level rises. These events can potentially result in large financial losses, lower wealth and lower GDP. An abrupt tightening of carbon emission policies could also lead to a negative macroeconomic supply shock (transition risks). This chapter reviews the channels through which climate risks can affect central banks’ monetary policy objectives, and possible policy responses. Approaches to incorporate climate change in central bank modelling are also discussed.
Sandra Batten, Rhiannon Sowerbutts, Misa Tanaka

Chapter 3. Global Warming and Extreme Weather Investment Risks

Environmentally focused investors often consider climate risks (Porritt, The world in context: Beyond the business case for sustainable development. Cambridge: HRH The Prince of Wales’ Business and the Environment Programme, Cambridge Programme for Industry, 2001, Stern, Stern review executive summary. London: New Economics Foundation, 2006); however, potential liabilities for damages from extreme weather events due to emissions from carbon-intensive sectors present risks that may not be reflected in current share prices (Krosinsky, Robins, & Viederman, Evolutions in sustainable investing: Strategies, funds and thought leadership. Hoboken, NJ: John Wiley & Sons, 2012). Given the devastation of the 2017 Atlantic hurricane season, it is worth asking: how close are we to some companies or sectors being held liable, at least partially, for their activities around emissions? The answer may be that this is closer than many expect. The evolving field of extreme weather event attribution serves as a good example of how new science can raise important thought-provoking questions regarding the appropriate actions of both investors and companies under a changing climate and answer them with increasing confidence.
In recent articles, Rayer and Millar (Investing in extreme weather conditions. Citywire Wealth Manager (429), 36, 2018a; Hurricanes hit company share prices. Citywire New Model Adviser (596), 18, 2018b; Physics World, 31(8), 17, 2018c) estimated that the top seven carbon-emitting publicly listed companies, under a hypothetical climate liability regime, might increasingly see around 1–2% losses on their market capitalisations (or share prices) from North Atlantic hurricane seasons. This chapter gives a comprehensive exposition of how that estimate was arrived at, as well as clarifying how it was quantified. Related aspects from a physical point of view are provided, with an associated general overview of the current state of the related science of climate change, alongside a focus on extreme weather events.
Quintin Rayer, Peter Pfleiderer, Karsten Haustein

Chapter 4. Mapping Out When and Where Climate Risk Becomes a Credit Risk

This chapter presents how different types of climate risk, transition risk and physical risk, can be assessed to understand the implications for the creditworthiness of debt issuers. It considers the methods to identify the most financially material issues for different sectors and types of entity, such as corporations and governments. In terms of energy transition risk, this work identifies the primary channels for transmitting risk: (a) policy measures, (b) market dynamics, and (c) technological change. For physical climate risk, it outlines the challenges of both long-term chronic trends and acute event risk. To determine the residual risk levels, potential mitigation measures that reduce the financial impact, such as contractual arrangements, insurance, and investment in adaptation, are discussed. A theme throughout the chapter is the temporal aspect of climate risk, which attempts to forecast the low carbon transition as well as the estimations of financial significance.
James Leaton

Chapter 5. Designing Insurance Against Extreme Weather Risk: The Case of HuRLOs

This article studies the market for HuRLOs (Hurricane Risk Landfall Option), launched in 2008 by Weather Risk Solutions. The HuRLO market allows investors to hedge against, or speculate on, the risk that a specific region in the Gulf of Mexico and on the East Coast of the United States will be the first to be hit by a hurricane. We simulate HuRLO market operations under various strategies used by risk-averse players using a formulation that accounts for the pari-mutuel price formation mechanism. We show that the order type, sequence, and order packaging significantly impact on the price paid, and on the number of traded options. We thus highlight that HuRLOs are difficult to evaluate and to purchase optimally, which limits the ability of the HuRLO market to act as an effective insurance mechanism. Potential improvements in the design of HuRLO contracts are suggested.
Martin Boyer, Michèle Breton, Pascal François

Chapter 6. The Evolving Risk Management Opportunity and Thinking Sustainability First

Risk management is evolving as a field, and one of the driving forces to the changes taking place is the growing importance of Environmental, Social, Governance (ESG) issues and the Sustainable Development Goals (SDGs). Opportunities in various forms are surfacing as actions to plans and strategies to mitigate the ESG risks are being formulated. There are many influencing factors on the evolution of risk management pertaining to sustainability, including the clarification of fiduciary duty, the changing roles for decision-makers on capital investments, the urgency on certain thematic issues, the creation of task forces, the development of taxonomies, the frameworks to establish materiality, the setting of goals and targets, and the progressive education and training. This mixture of factors is the new ecosystem, which is emerging in the corporate and investment sectors and includes the participation of governments and nongovernment organizations. The bottom line is that educators need to prepare the training of our current and next generation of decision-makers in this evolving trend in which sustainability will take priority.
Stephen Kibsey, Stéfanie D. Kibsey, Amr Addas, Cary Krosinsky

Societal Risks


Chapter 7. Terrorism and Trading: Differential Equity and Bond Market Responses During Violent Elections

Equity market investors gauge future corporate profits and sell shares when negative news announcements threaten future earnings. Comparatively, sovereign bonds sell off when economic conditions darken, and bond yields rise accordingly. Together, stock and bond markets amount to an intricate crowd-sourcing mechanism for acting upon perceived changes in, among other things, political risk. Frontier financial markets present particularly esoteric market information systems, and elections in frontier markets present a particularly fraught opportunity for study. Using a robust data set on electoral violence, this chapter assesses financial market responses to reports of electoral violence during the 2013 general elections in Pakistan. It will contribute to wider interdisciplinary discussions of political risk by offering constructs from finance which may clarify perceptions of, and responses to, civil strife in frontier economies during discrete time periods.
Allan Dwyer, Tashfeen Hussain

Chapter 8. The Effect of Corporate Tax Avoidance on Society

Tax avoidance is legal, but when maximized using methods that are available to multi-national corporations some methods to avoid taxation become indistinguishable from tax evasion or fraud. The amounts are significant and can exceed the entire budget of some developing countries. Developing countries are affected differently from developed countries. The objectives and strategies used by their governments differ as well. The relative strengths of industrial, individual, and governmental participants vary greatly as well. Surprising and interacting coalitions arise and wane.
This chapter will summarize the strategies, the methods, and the rules that enable extreme tax avoidance. Many approaches are enabled by laws and regulations that are well-intended and seem appropriate for a country’s economic well-being. How alternate means of collecting and distributing global tax revenues affect the well-being of a country is rarely well understood and easily disregarded.
A classification of approaches according to the state of development of a country provides little guidance, since any significant scheme involves many jurisdictions. Hoping that world-wide joint and coordinated efforts could solve the issues appears futile. The intent of this chapter is to provide a basis for future discussion, and perhaps actions.
Gio Wiederhold

Chapter 9. Planning for the Carbon Crisis: Reimagining the Power of the US Central Bank and Financial Institutions to Avert a Twenty-First-Century Climate and Financial Disaster

The energy industry in the United States is headed toward an economic crisis with disastrous financial and climatic implications, both with national and global consequences. Future litigation against fossil fuel companies, potential aggressive regulation on extraction, and ever-decreasing renewable energy prices all stand as major threats to fossil fuel companies. Even as this potential looms, oil, gas and coal companies continue over-valued. When these pressures come to bear, market corrections could trigger a global financial crisis many times greater than that of 2008. This contribution aims to expose the looming carbon bubble threat in the US financial system. Additionally, it aims to explain how the Federal Reserve along with new and re-envisioned financial institutions, such as a national Green Investment Bank and a network of regional and local public banks, can pro-actively start deflating it today by enabling a planned transition away from fossil fuels.
Carla Santos Skandier

Chapter 10. Economic Risks from Policy Pressures in Montreal’s Real Estate Market

This chapter aims to respond to the question of: How can developers navigate the regulations so as to maximize the financial viability of a real estate project? There are many new regulations being implemented in Montreal, such as the 20-20-20 by-law and the REM Tax, explained in subsequent paragraphs in this chapter; however, this chapter will focus solely on the impacts of the social housing component of the 20-20-20 by-law. This key focus has become increasingly important for cities since the aim of such by-laws are to make cities more inclusive and accessible. However, the by-laws are developing in different ways in cities around the world. This chapter focuses only on the introduction of the social housing by-law for Montreal. We will address this in three steps. First, we briefly describe the growth experienced in the real estate market to date in Montreal. Second, we outline the new policy changes for affordable housing and transit. And finally, we explore the financial impact of three potential ways in which the social housing by-laws can be enforced. We conclude with a summary of our findings.
Carmela Cucuzzella, Jordan Owen

Chapter 11. Climate Change and Reputation in the Financial Services Sector

This contribution looks at the role climate change and reputation play in the financial services sector. It examines how reputation is defined (e.g., difference to brand or image) and which role climate change and its related risks (e.g., transition or physical) play. This is examined in the context of disclosure recommendations that are not yet obligatory but widely applied to inform about governance, strategy, and risk, as well as metrics and targets.
The hypothesis is that climate change-related risks magnify the effect of reputation risks. Financial institutions that provide products and services in accordance with the values on which they pretend to rely for doing business experience more positive consequences than those who provide products and services in a way that the consumer experiences a negative deviation compared to the reputation-based expectation. This gap in integrity, credibility, and trust is a risk that might become a subsistence threat. This chapter is crucial for financial institutions to stay relevant.
Robert E. Bopp

Chapter 12. Financial Risk Management in the Anthropocene Age

We examine the financial risk management of the climate crisis from three perspectives. First, we assess the serious risks from climate change. The ecological and financial consequences of climate change depend on the future path of emissions, as well as the specific circumstances of specific countries and populations. Second, we assess the previous success of market solutions through pricing sulfur and carbon dioxide emissions. Finally, we demonstrate the critical role of the insurance industry in creating incentives to reduce emissions and to invest in adapting to the climate changes that are already inevitable.
Bradly J. Condon, Tapen Sinha

Technological Risks


Chapter 13. An Incentives-Based Mechanism for Corporate Cyber Governance Enforcement and Regulation

A growing literature in finance examines the impact of cybercrime on equity markets and publicly traded corporations, with an emerging strand of this literature investigating the contagion channel from cybersecurity breaches against the publicly traded companies, to broader market volatility. The dominant responses by the corporations to these threats can be described as ‘test internally for internal vulnerabilities’, and the ‘insure and forget’ approach, both of which imply a lack of significant preventative actions by companies under the risk of an external cybersecurity attack. The evidence of growing adverse impact and risk of hacking events on firms’ market valuations is highlighted by (i) the rising cumulative abnormal returns impact of such events, (ii) the rising systemic contagion effects of hacks, and (iii) the lack of robust regulatory mechanisms for systematic prevention, mitigation, and enforcement of data security breaches. This supports our proposal that when acting under regulatory authority’s supervision from within a ring-fenced incentives system, ‘white knight’ hackers may provide the appropriate mechanism for discovery and deterrence of weak corporate cybersecurity practices and systems. This mechanism can help alleviate the systemic weaknesses in the existent mechanisms for cybersecurity oversight and enforcement in financial markets.
Shaen Corbet, Constantin Gurdgiev

Chapter 14. FinTech for Consumers and Retail Investors: Opportunities and Risks of Digital Payment and Investment Services

Payments and investments are part of consumers’ everyday life and vital to society and its economic and social systems. As the evolution of FinTech has laid the foundation for the next generation of technical innovation in the financial service sectors, this chapter discusses examples of FinTech innovation and analyzes their opportunities as well as their ecological, societal, and technological risks from consumer and retail investor perspectives. While FinTech innovation has the potential to make financial services easier, cheaper, and better available, all payment and investment services discussed in this chapter have in common the technological risks arising from the possibility to (mis)use consumers’ and retail investors’ data for price discrimination or identity theft. Cryptocurrencies additionally pose ecological risks due to their enormous energy demand, while the new investment services may help retail investors to decrease the ecological risk of their portfolios. The societal risks of FinTech overlap or coincide with the technological risks, for example, when consumer data is used to discriminate groups of consumers. In addition, the high degree of anonymity in cryptocurrency networks and the lack of centralized supervision can provide an ideal playing field for criminal activities such as money laundering and tax evasion that threaten consumer and retail investor welfare.
Matthias Horn, Andreas Oehler, Stefan Wendt

Chapter 15. Empirical Modelling of Man-made Disaster Scenarios

This contribution discusses the empirical modelling of man-made disaster scenarios by modelling the frequency and severity (collective risk model) of man-made catastrophes based on historical industry loss data. Due to the various triggers that require separate modelling approaches, the contribution focuses on man-made fire/explosion disasters since recent events, such as the Tianjin harbor explosion, have shown the significance of this disaster type and its impact on the insurance industry and other markets. Ultimately, empirical modelling will be applied to develop an aggregate loss curve to reflect man-made fire/explosion disasters properly.
Melanie Windirsch

Chapter 16. Changing Dynamics of Financial Risk Related to Investments in Low Carbon Technologies

The Paris Agreement under the United Nations Framework Convention on Climate Change (UNFCCC) emphasizes the need to mitigate the impact of climate change. Mitigating strategy involves reducing the use of carbon-intensive technologies such as coal while promoting low carbon technologies. However, this strategy may lead to abrupt changes for the coal industry with limited time to respond. This article illustrates the perceptions of the financial sector toward policy goals, guidance, and instruments to encourage low carbon technologies as well as their impact on coal-based technologies. Although the industry’s intention to move toward low carbon is clear, the need for reliable and cost-effective power to drive the economy often results in policies that prioritize economical and proven technologies and leads to policy uncertainties which present new challenges and risks to investors and financial institutions alike. In the case of coal, on one hand the shift to low carbon technologies has led the financial sector to regard coal technology as increased investment risk or “stranded assets” for investors. On the other hand, a lack of financing has resulted in a lackluster low carbon industry with the financial sector questioning its long-term direction. As such, financing and sound policies are key in mitigating climate change while managing existing assets. To illustrate this shift, this chapter discusses policy goals and instruments, such as government subsidy, into the coal industry or coal-related industry. It also examines climate change-related policy goals, such as long-term energy goals to increase renewables, and promotion instruments, such as the feed-in tariff. In view of these changing policies, the chapter addresses new opportunities for the financial sector as well as new perspectives to recognize climate change as a means to reduce the risk for low carbon technologies. A holistic view is needed by considering the unique feature of these technologies and also the changing landscape of global policies toward mitigating climate change.
Mohd Hafdzuan Bin Adzmi, Huiying Cai, Masachika Suzuki

Chapter 17. A New Era in the Risk Management of Financial Firms

This contribution analyzes how new technology has changed the risk management landscape for financial companies. Accelerating technological innovations in the finance industry have disrupted the old order and created new challenges and opportunities along with new front-runners and followers. New payment systems, digital currencies, and digital investments are just some examples of these innovations. Formerly self-sufficient financial companies had to collaborate with FinTech companies in order to protect market shares. Technological innovations and collaborations among companies in the finance sector do not create new risks; rather, they increase the affectedness to some risks types and extend the definition of traditional risks, such as operational, reputational, and legal risks. E-financing activities, outsourcing in financial companies, and cyber threats are the major new risk sources that financial companies must embed to traditional risks. Risk management principles in the digitalization era guide the risk manager to tailor specific practices for each finance company.
Sureyya Burcu Avci

Chapter 18. Emerging Risks: Concluding Remarks

The contributions in this book provide evidence of the intensity and variety of changes in our ecological, societal, and technological environment and their implications for the financial sector. In addition to highlighting the potential opportunities and threats emerging risks bear for financial institutions and markets, the chapters outline the role the financial system can play in positively affecting its environment. They point to the reciprocal dependency of the different systems and the need to consider these interactions. In doing so, emerging risks appear to matter more than ever.
Dieter Gramlich, Thomas Walker


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