But in many respects they highlight the inadequacies of existing regulations. The ease and cheapness of gathering, processing and disseminating information has encouraged financial innovation in a number of areas, including the development of screen-based trading systems, securitisation and the proliferation of derivative products. One of the regulatory responses to financial conglomerates is the adoption of consolidated supervision. Regulators should consider whether various businesses within a conglomerate (banking, securities, insurance, etc.) should be consolidated in an accounting sense for the purpose of calculating capital adequacy and other prudential ratios, and for assessment in general. The more general view expressed, for instance, in European financial market directives and Basle regulatory guidelines is that like activities should be treated identically for supervisory purposes, regardless of the category of institution. It is also important that bank and securities regulators co-operate at the international level. Financial innovation, e.g. derivatives trading, creates transparency problems for regulators, because of the speed and complexity of risk transformation. The appropriate response of market transparency is more extensive disclosure of financial information. But in the context of fast-moving derivatives business the difficulty is to formulate effective disclosure rules that do more than provide an outdated snapshot of risk exposures. For management of financial institutions, the main emphasis must be on internal controls. External regulators, such as the Basle Committee and IOSCO, have responded and issued detailed guidelines on risk management.
For example, extreme weather events – which have been steadily increasing over recent decades3 – can harm borrowers’ ability to repay their debts and thus make the loan portfolios of banks much riskier. These risks can be further heightened if extreme weather events also depreciate the value of the assets used as collateral in those loans. Transition risks, on the other hand, include the financial losses that can directly or indirectly result from the process of adjusting to a low-carbon and more environmentally sustainable economy. This adjustment could be triggered by legislation, such as carbon pricing or the banning of carbon-intensive activities. Even independently from that, consumer preferences could shift towards goods and services that are more climate-friendly. An ECB initial assessment confirms that an abrupt transition to a low-carbon economy would have a severe impact on climatesensitive economic sectors, with consequences for up to one-tenth of banking sector assets if the creditworthiness of the highest carbon emitting firms is reassessed, and affecting more than half of banking sector assets if entire economic sectors are reassessed.4 And preliminary results from our ongoing climate stress test show that without further policy action, companies will face substantially rising costs from extreme weather events. This will greatly raise their probability of default.5 Both physical and transition risks will become increasingly material for banks in the coming years, and ECB Banking Supervision has identified climate change as one of the key risk drivers for the European banking sector.