From nature shocks to financial stability Incorporating nature physical risks – in particular water-related risks – into banks’ credit risk models and insurers’ market risk models

This paper presents a top-down stress testing framework for estimating the financial (stability) impact of nature degradation. The methodology links the three components of the NGFS conceptual framework on nature-related risks: nature, the economy, and the financial sector. In the first step, a shock on nature, e.g. water scarcity, is calibrated based on the macroeconomic impact of proxy scenarios of nature degradation. We then estimate the impact of this shock on nature on companies. For this, we modify the Merton model (Merton, Robert C. 1974) to account for the vulnerability of companies to nature. The resulting higher probabilities of default are the main driver of credit and market risk losses for banks and insurers respectively. While the framework we introduce is general and can be applied to multi-dimensional nature shocks and joint climate-nature shocks, in quantification we focus on water as a sub-category of nature. The results show that the financial‑stability implications of nature‑related disruptions can be quantified in a coherent manner. Losses are allocated according to sectoral, geographical and ecosystem‑service vulnerabilities. The framework delivers granular indicators – from sectoral production impacts to market revaluations and prudential ratios – supporting a wide set of analytical and supervisory applications.

Keywords: nature degradation; ecosystem services; biodiversity loss; dependence score; financial stability; risk; credit risk; market risk; Merton mode
JEL codes G21; G28; Q57

Working paper no. 857