Issue 3: Climate Risk → Credit Market Contraction
Welcome back to Fed Lit, our monthly newsletter profiling essential climate literature for Federal Reserve staff, leadership, and all other interested parties.
“The Macroeconomic Impact of Climate Risk on US Financial Stability and Credit Markets” By Zannatus Saba and Sabah Abdulla
This month we’re looking at an ambitious working paper from January of this year. The authors zero in on climate risk as it affects credit markets, various Federal Reserve financial stability indicators, and the Fed’s 2024 Dodd-Frank Act Stress Test analysis of 31 banks. There is a lot here—too much for one issue—so let’s focus just on these authors’ insights regarding the effect of climate risk on credit market conditions.
Last month, Allianz SE advisor Günther Thallinger posted a grave warning about the impact of climate-driven uninsurability on credit. He says, “No bank will issue loans for uninsurable property. Credit markets freeze. This is a climate-induced credit crunch.” Thallinger explains that this credit freeze limits more than just lending in housing markets; it also limits lending for infrastructure, agriculture, transportation, and industry. He concludes that with these credit market freezes, induced by the loss of insurance, “capitalism as we know it ceases to be viable.” This struck us as alarming and made us curious about why banks cannot find ways to compensate for the loss of insurance coverage—either with compensating collateral packages or with risk-adjusted interest rates. So we looked more closely into credit market dynamics.
“The Macroeconomic Impact of Climate Risk on US Financial Stability and Credit Markets” corroborates Thallinger’s point about climate-driven credit contraction but stops short of predicting the fall of capitalism. Using data from the International Monetary Fund’s 2022 Global Financial Stability Report, the authors analyze the effects of higher average temperature on both corporate credit demand and loan standards—the latter being a proxy for credit supply. Using the Federal Reserve’s quarterly Financial Stability Report, the authors look at the effect of higher average temperature on particular financial stability metrics. Finally, the authors combine the market volatility index (VIX) with heightened climate risk to measure their joint impact on credit supply.
Key Findings:
Climate risk, measured by an increase in maximum temperature, leads to a decrease in credit demand and an increase in the stringency of loan standards.
Climate risk depresses household and business borrowing activity. A one-degree increase in maximum temperature leads to a decrease in the private nonfinancial sector credit-to-GDP ratio.
Market volatility enhances the temperature-driven impact on loan standards. The joint impact of a one-degree increase in maximum temperature and a one-unit increase in the VIX contributes an additional increase in the stringency of loan standards.
Why It Matters:
When increased climate risk chills credit demand and supply, it thwarts the ability to access credit at non-risk-adjusted interest rates. As temperatures steadily—or nonlinearly—climb, we can expect that this credit contraction will not reverse on its own.
Market volatility amplifies climate risk. As the past month of tariff whiplash has indicated, we are in a time of heightened volatility. The Fed’s projections could be underestimating the impact of tariff-induced market volatility on credit markets if they are not incorporating climate risk.
Is This Fed Business?
Each quarter, the Federal Reserve Board assesses vulnerabilities to the financial sector related to stability by focusing on asset valuation pressures, borrowing by households and firms, leverage in the financial system, and funding risks. To enhance the credibility of this assessment, the Fed should include climate risk drivers in these focal areas. This paper demonstrates how easily this could be done using the Fed’s own compiled data. By failing to do so, the Fed is not providing an accurate picture of the effect of climate risk on financial stability indicators and credit conditions.
The Federal Reserve also publishes a quarterly Senior Loan Officer Opinion Survey that solicits input from up to 80 large US banks and 24 US branches of foreign banks on trends in their lending standards for various loan categories, as well as loan demand. The Fed should update the survey questions in this report (specifically questions 3, 5, and 31) to offer respondents the option to indicate if mounting climate risk weighs in their projections of loan demand or their decision-making when tightening lending standards. Currently there is no mention of climate as a potential driver in these quarterly shifts. Collecting this information will help us better understand drivers in credit contraction from the lenders’ perspective directly.
A Closer Look at the Research
The authors examine five hypotheses in this working paper. Here we focus on two of them:
Higher levels of climate risks are associated with tighter credit market conditions.
On the credit demand side, firms and household borrowers internalize elevated climate risks—in the form of average temperature increases—manifesting as climate-driven uncertainty, which dampens economic activity. In particular, this climate-driven uncertainty limits opportunities for investment, reflecting concern regarding future climate-driven financial disruptions. The authors find that temperature increases did in fact dampen credit demand, with a one-degree increase in maximum temperature leading to a 0.009 standard deviation decrease in loan demand.
On the credit supply side, elevated climate risks—again in the form of average temperature increases—push financial institutions to take precautionary measures to mitigate potential losses. As the authors describe, these measures include tightening loan standards, increasing borrowers’ collateral requirements, and/or charging higher interest rates for climate-risky sectors. A one-degree increase in maximum temperature led to a 0.003 standard deviation increase in loan standards.
Taken together, these findings on both the credit demand side and the credit supply side suggest that climate risk can spur contraction in credit markets—disincentivizing borrowing and imbuing caution in lending.
Using the Federal Reserve’s own financial stability reporting data, the authors demonstrate the influence of climate risk variables on asset valuation, household and firm borrowing, degree of leverage, and funding risks. The Fed reports on credit condition impacts using a ratio known as the private nonfinancial sector credit-to-GDP ratio. This ratio describes the overall credit conditions in the economy and was most recently reported in Q2 of 2024 at 1.44, or 144 percent of GDP. Accepting this measure as a benchmark for credit supply and using quarterly data from 2010 to 2022, the authors, once they include climate risk variables, find that a one-degree increase in maximum temperature leads to a 0.175 unit decrease in this ratio.
These findings further support the hypothesis that climate risk enhances credit market tightening. The authors state:
As businesses face higher risks or costs associated with climate change (e.g., infrastructure damage from heat waves or floods, increased energy costs), lenders demand higher interest rates or become more cautious in issuing loans. This reduces credit availability, contributing to the observed negative relationship between maximum temperature and the private nonfinancial sector credit-to-GDP ratio.
Market volatility amplifies the relationship between climate risk and credit demand and supply.
Finally, this paper considers market volatility as an amplifying force—exacerbating the contractionary impacts of climate risk. Using the VIX produced by the Chicago Board Options Exchange, the authors find that a one-unit increase in market volatility combined with a one-unit increase in maximum temperature adds a 0.0006 standard deviation increase in loan standards. This indicates that when market volatility is increasing at the same time as climate risk, the contraction to both credit demand and credit supply is exacerbated. These results are intuitive, and they echo the results from our Issue 2 focus paper last month—where economic uncertainty combined with temperature increases produced significantly greater economic contraction.
This past month we’ve witnessed extraordinary market volatility, with the VIX peaking at 52 points—for comparison, the Great Recession saw a peak VIX of 80 and COVID-19 a peak of 65. In the midst of such policy chaos and resulting economic contraction—and fears of recession—it’s tempting to dwell in the flooded zone when looking for explanatory variables. This paper highlights what we and the Federal Reserve miss when we fail to also incorporate the ongoing and mounting climate risk drivers of economic conditions. Unlike an ill-considered tariff policy, which is turned on and off on a whim, climate risks are embedded and need to be reflected.
You can agree or disagree with Thallinger’s prediction that a lack of insurability will lead to a credit freeze. Indeed, Fed Chair Jerome Powell himself has expressed concern about a future where it is no longer possible to secure credit to purchase a home. This paper demonstrates that there is a statistically significant relationship between rising temperatures and credit conditions, though these results don’t themselves foretell an imminent credit freeze. The paper does show that calibrating the extent of these effects is possible and provides a more comprehensive picture of the credit market conditions that result from higher average temperatures. If the Federal Reserve updates its data collection to include surveys related to climate risk, it can develop an even clearer picture of the causal links between rising temperatures and credit contraction.
To cite this paper:
Saba, Zannatus, and Sabah Abdulla. 2025. “The Macroeconomic Impact of Climate Risk on US Financial Stability and Credit Markets.” Available at SSRN. January 25, 2025. https://ssrn.com/abstract=5120845.