Why is it Urgent to Integrate Disaster Risk Management into Macro-prudential Supervision?

*= Luego del post del 28 de febrero último, y en consideración del tema, que es de interés internacional, y de que varias personas interesadas me manifestaron tener cierta dificultad en leerlo en castellano, lo publico en versión inglesa, actualizada y adaptada a una lectoría no hispanohablante

 At the end of this February, I developed this idea in a post written in Spanish mainly for the Peruvian public, and for the Spanish-speaking world. But not all those working and living in other regions can read Spanish, as it was rightly pointed out to me, while this issue can be of interest for financial institutions and financial regulators/supervisors in the developing and emerging economies. That’s why I am also writing it in English.

 All those who have been reading my posts all these years may have noticed that I have been mentioning the importance of the impact that natural disasters can have on assets quality and financial stability, and how Disaster Risk Management (DRM), which includes issues such as insurance penetration, public sector continuity planning and business continuity planning and the ability of Government, businesses and communities to handle disasters, should be considered as part of macro-prudential supervision and regulation. Nonetheless, it looks like at the global level and across the World, financial regulators/supervisors are not familiar with this idea, which does not seem to occur to them at all. May be because all their minds and energies remain focused on how to deal with the lessons of the protracted Financial Crisis which began in 2007/2008 and the heated debates still going on about them, as recent disagreements about capital standards have recently shown.

 As a tribute to the magnitude of the Crisis, and its rare and extreme combination of misdeeds and mistakes, from both bankers and financial regulators/supervisors in the developed countries, I should also say that when I wrote a working paper about Macro-prudential Supervision and Regulation released in November 2011 by Peruvian think-tank Instituto del Perú headed by former central banker Richard Webb (author of a book about the history of microfinance in Perú, by the way), I preferred not to mention the “disaster risk vs. financial stability issue”, moved by the feeling that not everyone in the Latin-American countries was drawing the right lessons from that Crisis, which was worsening with the rapid deterioration in Europe (most were still in “oh-yeah! That huge mess up North which affects our exports-we are doing things so much better” thinking mode; Messrs. Wellink and Ingves, former and present Heads of the BCBS had already rightly warned against complacency and not taking into account Basel III in emerging markets).

And this, in spite of my being impressed by the impact of the Marmara/Izmit earthquake in Turkey in 1999, which reminded me of the consequences of the El Niño in Peru both in 1982/1983 and 1998 on the financial institutions’ assets quality.  Basically I could see there the same lethal combination of financial crisis and a natural disaster as a worsening factor. When Pisco in Peru was struck by a 8.0 Mw earthquake in 2007, I could not avoid thinking: and what if the same event had hit Lima and Callao? By the way I kept thinking the same about Istambul and other key large cities with the same concern, as in many emerging countries very large cities in terms of share of national GDP are also heavily exposed to natural hazards. So, my only hint at the issue was a comparison of financial crises with earthquakes and their aftermaths.

 During 2012, I launched in this newspaper (Gestión), two “trial balloons” about the disaster risk/country risk issue, first mentioning in March lack of water (which can be caused by severe droughts) among key “strategic country risks”, and then in a post about “operational risks” in housing and the “systemic catastrophic risk” they could trigger. And I have continued ever since, with issues like insurance penetration and business continuity planning with a systemic view.

 But, when reading all the documents coming from “Basel”, I could not find anything about the risks deriving from “natural disasters” and their impact on financial stability. Well, it looks like this hasn’t changed much ever since. Just have a close look at two extremely interesting documents released in 2016 that any financial regulator/supervisor should read.

First, the “Elements of Effective Macro-prudential Policies” published last August by the FSB (Financial Stability Board), the BIS and the IMF about the international experience in macro-prudential regulation and supervision; the word “disaster” is nowhere to be found, as if only pure economic and financial shocks could exist. And then, the Occasional Paper of last October from the FSI (Financial Stability Institute), “Supervisory Priorities in non-Basel Committee Jurisdictions” (in short, basically in emerging economies): the challenge of disaster risk, even in the form of climate change is not mentioned in the survey, as part of the key concerns of those “jurisdictions”; it does not even appear under the “Others” section, and within the latter’s detail, neither; one may wonder if at least it is part of the small list of “other challenges mentioned only once”.

 This is all the more puzzling, since, as I discovered mostly from 2015 on, there were already more than hints at how “natural disasters” could hit the economy and thereby affect financial stability, and even at how better insurance penetration could play a significant mitigating role, in terms of increasing the speed of recovery and of reducing the burden for public finances:

. a working paper for the BIS dated December 2012, written by Sebastian von Dahlen, Goetz von Peter and Sweta Saxena. The title begins with the words “Unmitigated Disasters?”

. also towards the end of 2012, the important British think-tank CEBR published with reinsurer Lloyd’s, a paper caller “Lloyd’s Global Underinsurance Report”

. in 2014 came the research report from think-tank The Geneva Association about “The Global Insurance Protection Gap”; even if it does not refer explicitly to what could happen to banks, bankers and their supervisors should carefully read it…

. and then came the already famous September 2015 report by Standard & Poor’s, beginning with “Storm Alert”, about how natural disasters could damage sovereign ratings and how insurance penetration could help mitigate this risk. And that month is an extremely significant one.

 Not only were research and new evidence confirming what any seasoned banker, and any experienced country-risk specialist knows pretty well from first-hand experience, about the link between disasters and NPLs, and beyond that, with potential systemic financial risk and threats to financial stability, but very significant changes were also happening in the international arena in terms of connecting natural disasters and climate change with the threats to financial stability.

 First, in 2015, under the APEC-Finance Ministers’ Process, the Philippines introduced the issue of disaster risk financing and insurance as key to the “financial resilience” of Economies, together with macro-economic policy and deeper financial markets, in what is called the Cebu Action Plan. I later learned that in 2014, the Philippines and Japan, also in Cebu, had mentioned in a meeting of the regional consultative group for Asia of the Financial Stability Board the importance of contingency planning in the financial sectors against natural disasters (in the light of the Tohoku earthquake and Haiyan typhoon).

 And in September of that same year (yes, the same month as the a/m S & P’s report), the Head of the Financial Stability Board, Mark Carney, also Governor of the Bank of England, delivered a remarkable speech about the impact of climate change on overall financial stability, as one of the main challenges for the insurance/reinsurance industry.  Shortly after, the Task Force on Climate-related Financial Disclosures (the TCFD) was born and it has recently closed the consultation for its draft recommendations, which will go to the FSB and the G-20. In the meantime the FSB has become a key partner for the Insurance Development Forum.

 I take the opportunity to remind that one should be realistic: the insurance/reinsurance industry cannot cover everything, unless you want it going bust, which would cause a big problem for everybody, and notably the financial institutions. Thence the huge importance of physical risk reduction by both the private and public sectors, which includes resilient private and public investment (including investment in risk reduction and preparedness), of public sector and business continuity planning, and of sound sovereign strategies for financial protection against disasters.

 And now we have the Economist Intelligence Unit, with the help of UNISDR, the UN unit in charge of promoting and monitoring the implementation of the Sendai Framework for disaster risk reduction, integrating disaster risk and its management in its country-risk analysis.

 And has anyone read the Recommendations that the OECD has made about each country having to manage its own “critical risks”? And the Reports from the World Economic Forum, which consistently mention disaster risk, climate change and lack/mismanagement of water (all those more inter-connected than people realize; I wrote something about this in posts about Lima and Cusco some time ago) as part of the main key risks.

It is time for financial regulators/supervisors in developing and emerging economies, to take decisive action, even if the disagreements about capital standards under Basel III still continue. And anyway, they already know, as their most prudent financial institutions also know very well, that capital levels must be kept high anyway (that’s why in many countries, they did not have to wait for Basel III, and even for Pillar 2 of Basel II to realize this). And they have a much stronger potential systemic risk due to the impact of natural disasters, so for them this issue of better integrating DRM into financial regulation/supervision standards is urgent. Especially when evidence shows that rain patterns are becoming more unpredictable and that losses are bound to increase due to growth and rapid, and often disorderly, urbanization.

 In the past, many financial regulators/supervisors and policy makers in developing and emerging countries have been able to create advanced financial supervision standards, being even at the forefront of innovation, as a response to their own challenges, without having to wait for international standards (for example in the field of microfinance). We have seen this throughout Asia-Pacific, in Africa and Middle East, and in Latin America and Caribbean. Regional regulators/supervisors fora can also help exchange experiences and ideas. This will be all the more necessary now that key international players either deny or play down the climate change problem or are against close international coordination in financial regulation/supervision.

 Financial stability must not be seen at the global level only, but also at each country’s level, as it used to be before this Crisis, and is not only a matter of “globally systemic financial institutions”. Sometimes a crisis in a developing or emerging country, which can derive from, or be worsened by, a large disaster, can trigger a larger regional crisis and even affect developed countries, as history shows. Consequences can be not only of the economic/financial type but also painfully human and social and even geopolitical.

  Here are some examples of the macro-prudential supervision measures that can be taken in order to better integrate disaster risk and its management in financial regulation/supervision:

 . stress scenarios on credit exposures of financial institutions (FIs), simulating large expected disasters or continued increased losses due to climate change

. incorporating into the FIs rating and scoring systems the evaluation of good and bad DRM practices of their customers, including business continuity planning (BCP) and degree of insurance take-up

. incorporating into their country-risk analysis , this for banks exposed to other countries’ risks, these countries’ exposure to disaster risk and the quality of its management, as the EIU does

. reinforcing regulation and supervision standards for BCP/DRP: more practice, more trials and tests, more “embedding” into the whole organization, less theory and “paper planning”

. increasing the importance of selling micro-insurance among credit standards related to microfinance

. the FIs should have a more active role in educating their customers in better DRM practices, such as BCP and insurance; this as part of their efforts to improve financial literacy among their customers

. more stringent capital and provisioning requirements when insurance does not really protect the customer himself, beyond the loan’s amount and insurance protecting the FI

. developing metrics, even simple, about insurance penetration, so as to better track progress in this field; this should always be part of any “financial stability report”

. the TCFD final recommendations could be implemented by financial markets regulators, drawing from the market’s best practices. adding other natural hazards

. if the country has a formal or “informal” financial stability council, disaster risk and DRM should be part of the issues to be regularly discussed

. the FIs themselves could develop this approach, both individually and through their own associations.

 As a conclusion, financial/insurance/capital markets regulators/supervisors, central bankers and FIs themselves can also strongly contribute to a country’s resilience against natural disasters. In some countries they are already doing it, fortunately. And Mark Carney and the FSB have already integrated climate risk as a supervisory concern at the global level, the next step is that every country do likewise with disaster risk, including also non-climate related natural hazards, according to their own risk profiles, without forgetting over-dependence of their supply chains from other countries. By the way, the FSB could also extend its approach to non-climate related hazards.

One should be aware that considering disaster risk as a kind of “tail-risk” can end up costing dearly to a country, and even to several countries at once.