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2023 | Book

Financial Risk Management and Climate Change Risk

The Experience in a Central Bank

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About this book

Financial risk management for institutional investors has recently grown in scope to include long-term sustainability considerations and climate change risk concerns. This book shows how a national central bank in the Eurosystem has adapted its financial risk management principles and practices against the background of non-conventional monetary policy measures and following the introduction of sustainability criteria, with a special role for carbon-neutrality. The topics covered include a market-based approach to evaluating credit risk, the development of an independent credit rating system, and the properties and limitations of agencies’ sovereign ratings. Furthermore, the book analyzes the integration of sustainability principles into strategic asset allocation and describes the use of machine learning techniques for discerning the role of the E, S and G variables in equity returns. The authors also discuss the growth of the global green bond market and the greenium, as well as the sustainability indicators for large portfolios of corporate and government securities. Given its scope, the book will appeal to all professionals working in the field who would like to know the state-of-the-art in these areas.

Table of Contents

Frontmatter

Monetary Policy and Financial Risk Management

Frontmatter
The Cost of Unconventional Monetary Policy Measures. A Risk Manager’s Perspective
Abstract
We examine the evolution of credit risk arising from monetary policy operations and emergency liquidity assistance on the Eurosystem balance sheet over the years 2010–2022. We employ a market-driven risk model relying on the expected default frequencies for sovereigns, banks, and corporates provided by Moody’s Analytics. Dependence between defaults is modelled with a multivariate Student-t distribution with time-varying parameters. We find that at the end of August 2022, shortly after the Eurosystem ended net asset purchases under its long-standing quantitative easing and therefore the balance sheet ceased to grow, risk was approximately equal to less than half of the value measured at the peak of the sovereign debt crisis in 2012, notwithstanding the almost threefold increase in the Eurosystem monetary policy exposure occurred since then. This is due to the launch of the Outright Monetary Transactions Programme and the Pandemic Emergency Purchase Programme, which succeeded in quelling market turmoil, thereby reducing the Eurosystem’s own balance sheet risk. Our findings support the view that, in periods of severe financial distress, sovereign risk for a central bank is largely endogenous.
Marco Fruzzetti, Giulio Gariano, Gerardo Palazzo, Antonio Scalia
The Eurosystem Collateral Framework and the Measures Introduced in Response to the Pandemic Emergency
Abstract
The European Central Bank, as other central banks, conducts lending operations only based on adequate collateral. As a consequence, the rules on assets that can be used to access central bank liquidity play a central role in the monetary policy implementation and become pivotal in periods of economic stress when banks increase their reliance on central bank refinancing. In response to the crisis triggered by the Covid-19 pandemic, the Eurosystem adapted its collateral and risk control frameworks in order to ensure that the euro area banks could maintain sufficient collateral to benefit from ample central bank liquidity, thus safeguarding the credit supply to the real economy. The measures adopted by the ECB and the Bank of Italy proved to be beneficial for the Italian and the other euro area banks.
Paola Antilici, Giulio Gariano, Francesco Monterisi, Alessandro Picone, Luigi Russo
Sovereign Ratings
Abstract
The chapter analyses the sovereign rating methodologies of DBRS, Fitch, Moody’s, and S&P. As a case study, we also replicate the four agencies’ model ratings (i.e. the basis of the rating committees’ qualitative assessment) to dissect the components of Italy’s ratings as of December 2020.
We find that rating processes and baseline methodologies are similar across the four agencies, whereas significant differences arise in terms of indicators and computational rules. As a result, model ratings—and, not unlikely, also the official ratings after the qualitative assessment—may diverge across the four agencies for the same sovereign issuer.
When we replicate the four agencies’ models for Italy, we find that the most favourable quantitative driver of the rating is the economy’s size as measured by GDP, which gets an AAA or equivalent score; additional economic strengths are the balanced external position and the solid institutional framework. The qualitative part of the rating, as described in the four agencies’ public reports on Italy, is instead driven by Italy’s risk factors which outbalance the assessment of some important sources of strength of the country (e.g. the 25-year track record of Government primary surpluses and the high private sector wealth).
Anna Michelina Di Gioia, Roberto Imperato
The Bank of Italy’s In-House Credit Assessment System for Non-financial Firms
Abstract
The Bank of Italy’s In-house Credit Assessment System (ICAS) is one of the sources for the valuation of collateral agreed upon within the Eurosystem’s monetary policy framework. It helps to provide liquidity to those Italian banks that cannot rely on an internal model (IRB). Its role has become all the more important in the aftermath of the financial crisis relating to the Covid-19 pandemic of 2020. The chapter first outlines the Eurosystem’s collateral framework and describes the Bank of Italy’s ICAS in terms of architecture and governance. It then presents in detail the underlying statistical model, including the definition of default adopted, and the validation process for the statistical model and for the expert system. The chapter concludes by providing data on the amount of collateral pledged with an ICAS rating and on the main features, including the probabilities of default, of the Italian non-financial companies rated by the system.
Filippo Giovannelli, Alessandra Iannamorelli, Aviram Levy, Marco Orlandi
The Role of Rating Agencies: Implications for the Financial System and Central Banks’ Efforts to Reduce their Reliance
Abstract
The financial crises of 2008 and 2010–11 have led regulators to seek ways to reduce mechanistic reliance on rating agencies: rating actions, and in particular sovereign downgrades, heavily affect the financial system—especially banks—and the real economy, also due to the existence of a ‘sovereign ceiling’ for domestic issuers. We analyse first the channels by which sovereign downgrades have an impact on sovereigns themselves, on banks and other financial institutions, on non-financial firms and, ultimately, on the real economy. After explaining why the Eurosystem needs credit ratings for monetary policy implementation and describing the way ratings are ‘hardwired’ in the Eurosystem’s and other major central banks’ collateral frameworks—most of the financial risks borne by the Eurosystem’s balance sheet arise from assets assessed by rating agencies—we provide an overview of the recent academic and policy debate, in particular of those authors who encourage the Eurosystem to end the use of agencies’ sovereign ratings and rely instead on the assessment of sovereign risk developed internally or provided by another European public institution. In the last section, we examine the extent to which the Eurosystem has so far reduced its reliance on rating agencies.
Piergiorgio Alessandri, Martina Bignami, Francesco Corsello, Aviram Levy, Gaetano Marseglia, Arianna Miglietta, Alfonso Puorro, Luigi Russo, Marco Taboga
The Incorporation of Climate Change Risk in the Eurosystem Monetary Policy Framework and the Decarbonisation of the Corporate Bond Portfolio
Abstract
Climate change risks have a significant impact on financial markets and banking activities. Macroeconomic and financial market disruptions linked to climate change and transition policies could affect the conduct of monetary policy and the ability of the Eurosystem to deliver on its price stability mandate. In July 2021, the ECB announced a review of its monetary policy strategy, which explicitly integrates climate change considerations, and adopted an action plan to incorporate climate change risk in the monetary policy framework. As part of this plan, in July 2022 the ECB announced measures for its collateral and risk management framework, as well as for the decarbonisation of the corporate bond portfolio.
Fabio Capasso, Roberto Imperato, Luigi Russo

The Integration of Climate Change in Financial Risk Management

Frontmatter
The Commitment to Sustainability in Financial Investments
Abstract
In economics and finance, sustainability has been empirically framed around the Environmental, Social and Governance (ESG) factors. In recent years, the urgency of climate change effects has become prominent in the sustainability debate. Policymakers have developed several initiatives aimed at reducing greenhouse gas emissions and contributing to sustainable development. In this context, the financial system can crucially mobilise resources to support the transition to a more sustainable economy. This chapter focuses on the integration of the ESG and climate-related risks into risk and investment strategies. It starts with a description of the main policy initiatives taken at the international and European levels and of the market developments in sustainable finance. We then discuss the role of central banks in scaling up sustainable and green finance, owing to the potential effects of ESG and climate risks on the central banks’ ability to pursue their institutional goals. Finally, we consider central banks’ initiatives in monetary policy, supervision, and portfolio management.
Enrico Bernardini, Marco Fanari, Franco Panfili
The Strategic Allocation and Sustainability of Central Bank Investments
Abstract
In recent years, the extensive recourse to unconventional monetary policy measures and the growing importance of the transition process towards a sustainable economy have given rise to new challenges for the Eurosystem’s central banks in managing financial risks. In this context, central banks’ investment strategies, whose goal is to reinforce capital strength, have been combined with the adoption of criteria aimed at fostering a sustainable growth model. This work describes the strategic allocation process for investment developed by the Bank of Italy and the methodology adopted for applying sustainability criteria to some of the portfolio’s asset classes.
Davide Di Zio, Marco Fanari, Simone Letta, Tommaso Perez, Giovanni Secondin
Machine Learning, ESG Indicators, and Sustainable Investment
Abstract
This study proposes a novel approach to partially overcome the current inconsistencies in the ESG scores by using Machine Learning (ML) techniques to identify the most material E, S, or G indicators that better contribute to the construction of efficient portfolios. The novelty of the chapter is threefold: (a) the large array of ESG indicators (more than 220) analyzed for a long-time span (from 2007 to 2019), (b) the ML model-free methodology, and (c) the disentangle of the contribution of ESG specific indicators to the portfolio performance from the traditional style and macroeconomic factors. According to our results, more information content may be extracted from the available raw ESG data for portfolio construction. Half of the ESG indicators identified with our approach are environmental. Among environmental indicators, some refer to companies’ exposure and ability to manage climate change risk, namely, the transition risk. This chapter shows that a European equity market investor who had applied our technique would have achieved a substantial extra annualized return.
Ariel A. G. Lanza, Enrico Bernardini, Ivan Faiella
The Global Green Bond Market
Abstract
This chapter presents a comprehensive study of the ESG bond market, which has experienced a strong growth in the last few years and is about to get an additional boost from the forthcoming implementation of the next-generation plan of the European Union. We use a security-level data set comprising a large sample of ESG bonds exchanged on the main global financial markets, integrated with microdata employed in official statistics, such as financial accounts and security holdings. First, we describe the most salient features of the global supply of ESG bonds by analyzing issuers’ and securities’ characteristics, the differences across countries, and sectors and their evolution over time. Second, we shed light on Italian residents’ holdings of ESG bonds by Italian residents, with a focus on sectoral holdings within the context of the financial account statistics. Finally, we briefly discuss the greenium puzzle, i.e. the negative yield difference between ESG bonds and their standard counterparts.
Danilo Liberati, Giuseppe Marinelli
The Exposure of Investments to Climate and Environmental Risks
Abstract
The management of the portfolio exposure to climate and environmental risks has become increasingly important among investors. Central banks have stepped up their efforts towards the measurement and disclosure of the exposure of their portfolios. This chapter describes the indicators available for the measurement of climate risks for bonds and equities. It distinguishes the available indicators for the assessment of the climatic and environmental risks of public sector issuers and corporate issuers, respectively. The chapter outlines the environmental sustainability profile of the Bank of Italy’s euro-denominated investment portfolios and foreign currency reserves. It describes the sustainable investment strategy of the Bank and the remarkable improvement in the climate-risk exposure of recent years.
Ivan Faiella, Enrico Bernardini, Johnny Di Giampaolo, Simone Letta, Davide Nasti, Marco Fruzzetti
Financial Risk Management and Climate Change Risk
Abstract
This book presents recent studies concerning: (1) the challenges for financial risk management at the central bank posed by the growth of the balance sheet; and (2) the integration of climate risk and sustainability principles into the investment policy. In 2022, shortly after the Eurosystem ended net asset purchases under its quantitative easing programmes, the risk was approximately equal to less than half of the value measured at the peak of the sovereign debt crisis in 2012, notwithstanding the threefold increase in the monetary policy exposure. This shows the effectiveness of the Outright Monetary Transactions (OMT) Programme and the Pandemic Emergency Purchase Programme (PEPP) in quelling market turmoil, thereby reducing the Eurosystem’s own risk. The central bank community has intensified the efforts towards environmental sustainability and the fight to climate change in several directions, as shown in 2017 by the establishment of the Network for Greening the Financial System (NGFS). The book presents the key measures of environmental and climate-related risks for sovereign issuers and corporate issuers, respectively. Although the availability of coherent and comparable indicators is incomplete, investors may to a large extent measure and manage the portfolio climate risks by employing public information yet to be fully exploited.
Antonio Scalia
Backmatter
Metadata
Title
Financial Risk Management and Climate Change Risk
Editor
Antonio Scalia
Copyright Year
2023
Electronic ISBN
978-3-031-33882-3
Print ISBN
978-3-031-33881-6
DOI
https://doi.org/10.1007/978-3-031-33882-3

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