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Long-term risks such as climate change, as well as inevitable risks such as global pandemics, are often ignored by financial market actors.

In response to the COVID-19 pandemic and the threat that it represents to society, the economy, and financial markets, 2° Investing Initiative is building on its risk management research to support our stakeholders in managing and mitigating the crisis.

Based on our preliminary modeling, the speed and magnitude of the disruption may eventually exceed the scale of past stress tests. Moreover, as with climate change, many shocks are cross-cutting, based on specific sector characteristics that are not considered in existing stress tests. The ‘Minsky Moment’ described by the Bank of England for climate risks – mixing economic disruption, policy responses, and overnight shift in market sentiment – is happening now, at scale, for COVID-19.

Building on 2DII’s work with supervisors, insurers and banks

Building on its work with supervisory authorities, insurers, and banks on climate stress testing, 2DII working on integrating COVID-19 risk into the ongoing stress testing, risk management and mitigation exercises that will be necessary in the coming months.

As part of this exercise, we are extending our existing partnerships with financial supervisors on climate stress testing and scenario analysis to “snap stress tests,” using a series of COVID-19 stress test scenarios. We will be working with the European Insurance and Occupational Pensions Authority (EIOPA) in the context of our existing partnership to use these scenarios as a way to strengthen their analysis of potential market impacts of the COVID-19 crisis.

As part of these efforts, we recently published a discussion paper outlining six COVID-19 stress test scenarios. To our knowledge, these are the first stress test scenarios for COVID-19 that have been developed. These scenarios will be improved on an ongoing basis in the next few months, integrating all the available inputs from other supervisors, financial institutions, credit rating agencies, and the broader research community, as the situation evolves.

2° Investing Initiative’s work on time horizons & risk management

Our research on COVID-19 stress testing scenarios builds on our previous work on what Mark Carney, former governor of the Bank of England, called the “tragedy of the horizon.”

These are risks that are material for a physical asset or company, but are not necessarily material for their investors and not necessarily priced in by financial analysts. In response, 2DII launched the ‘Tragedy of the Horizon’ research project in 2016. Find out more about the project and related papers here.

 

Note on the funders: Our COVID-19 stress testing research has received support from EIT Climate-KIC.