This is usually a very effective risk management technique during periods when CDS markets function normally. But it is worth emphasizing that the embedded “jump to default” risks in credit products, coupled with liquidity issues during times of extreme stress, can make it very difficult to execute a dynamic hedging strategy in stressed conditions. In addition, and as already noted, CVA hedging is likely to be undertaken by buying CDS from another bank or a hedge fund. In this example we have tail-risk correlation not just with corporate and counterparty risk but with CDS market liquidity. If proper consideration to the correlation structure is not applied, the danger is clearly that the realized outcome in extreme scenarios would look very different from what was expected by senior management, regulators, etc., based on local analysis. A fourth example from the recent crisis was the “super senior” credit exposure from pools of US mortgage loans reinsured with monoline insurance companies (MBIA, FGIC, AMBAC, etc) or other insurers such as AIG. Banks and other originators of leveraged credit risk (either in cash form of CDOs or CLOs, or in its synthetic forms) needed to warehouse excess “super senior” tranches, which were considered virtually risk free, to support the origination business. After the volatility experienced in 2005, banks started to worry about controlling the mark-to-market volatility, even though the fundamental risk initially continued to be considered negligible. The idea came to lay off a significant portion of this negligible economic risk to reduce the short and medium term price volatility.
Importance of scenario analyses and stress tests A second challenge arises from the lack of satisfactory analytical tools to measure the impact of climate change on traditional financial risks and on the resilience of banks and the financial sector as a whole. Scenario analysis exercises and stress tests are particularly appropriate: their forwardlooking nature and the ease with which numerous assumptions can be included make them especially suited to measuring these risks. 14  Proposal for a Corporate Sustainability Reporting Directive (CSRD), European Commission, April 2021. 15  Basel Committee on Banking Supervision press release, BCBS, November 2021. 5  These instruments are not new. Indeed, they have been used by supervisors for prudential purposes since the last global financial crisis. However, some significant adaptations are needed to capture the complexity and uniqueness of climate risks. In this respect, the BCBS published a report in 2021 analysing the main problems that arise when measuring these risks.16 Essentially, three difficulties stand out: the complexity associated with the design of different physical and transition climate-risk scenarios, the need to incorporate different time horizons into the assessments and the operational problems involved in carrying out these exercises, in terms of the data and resources required. As regards the scenarios, the NGFS has developed a set of scenarios intended mainly for central banks and supervisors, which may also be useful for stress tests for financial institutions.