Climate Transition Risk, Climate Sentiments, and Financial Stability in a Stock-Flow Consistent approach

It is increasingly recognized that banks might not be pricing adequately climate risks in the value of their loans contracts. This represents a barrier to scale up the green investments needed to align the economy to sustainability and to preserve financial stability. To overcome this barrier, climate-aligned policies, such as a revision of the microprudential banking framework (for example a Green Supporting Factor (GSF)), and the introduction of stable green fiscal policies (for example a Carbon Tax (CT )), have been advocated. However, understanding the conditions under which a GSF or a CT could represent an opportunity for scaling up green investments, while preventing trade-offs on risk for financial stability, is still insufficient. We contribute to fill this knowledge gap threefold. First, we analyse the risk transmission channels from climate-aligned policies, a GSF and a CT, to the credit market and the real economy via loans contracts. Second, we assess the reinforcing feedbacks leading to cascading macro-financial shocks. Third, we consider how banks could react to the policies, i.e., their climate sentiments. In this regard, we embed for the first- time banks climate sentiments, modelled as a non-linear adaptive forecasting function into a Stock-Flow Consistent model that represents agents and sectors of the real economy and the credit market as a network of interconnected balance sheets. Our results suggest that the GSF is not sufficient to effectively scale up green investments via a change in lending conditions to green firms. In contrast, the CT could shift the bank's loans and the green/brown firms' investments towards the green sector. Nevertheless, it could imply short-term negative transition effects on GDP growth and financial stability, according to how the policy is implemented. Finally, our results show that bank's anticipation of a climate-aligned policy, through stronger climate sentiments, could smooth the risk for financial stability and foster green investments. Thus, our results contribute to understand the conditions for the onset and the mitigation of climate-related financial risks and opportunities.Series: Ecological Economic Paper