MAS flags climate change, crypto-assets as emerging long-term vulnerabilities to global financial system

• While not pronounced risks yet, the Monetary Authority of Singapore said that climate change and crypto-assets could emerge as vulnerabilities in the next three to five years
• There may be transition risks to bank loans as the world transitions to a low-carbon economy
• Crypto-assets and their markets would become significant in relation to future stability given their continued growth, said MAS

SINGAPORE — The Monetary Authority of Singapore (MAS) has flagged climate change and the increasing prominence of cryptocurrencies as emerging vulnerabilities that could pose a risk to the stability of global financial systems over the next three to five years.

“While these risks may be less pronounced at this juncture, they warrant close monitoring and an active assessment of options due to their potential to rapidly develop and materialise into significant financial stability risks,” said Singapore’s central bank in its annual review of the city-state’s financial system released on Monday (Dec 6).

Besides these longer-term vulnerabilities, other risk factors include a build-up in corporate debt, higher sovereign debt levels, as well as rising financial asset prices — a result of governments rolling out stimulus packages to soften the economic blow from Covid-19.

Setbacks to economic recovery resulting from a resurgence of the pandemic, tighter financial conditions due to higher inflation, as well as the premature withdrawal of financial support from governments could introduce shocks to the financial system.

Overall, though, MAS said that financial conditions have remained conducive despite persistent market expectations of tighter monetary policy due to inflationary pressures, and risks have remained largely contained this year.

CLIMATE CHANGE

With greater recognition of the risks arising from climate change, MAS noted global efforts to transition to a low-carbon economy but said this came with two types of risk.

First, there would be physical risks, which refers to the economic costs and financial losses from the exposure of human and natural systems to climate-related events.

Second, there would be transition risks, which are the economic and financial costs of the adjustment to a low-emissions economy, including those induced by policy changes, technological breakthroughs, and shifts in investor preferences and social norms.

MAS said that increasing awareness on climate change could trigger an abrupt reassessment of physical and transition risks, leading to a sharp increase in risk premiums across a wide range of assets seen as incompatible with a low-carbon economy.

The risk premium refers to the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset.

“It is thus imperative for financial institutions and authorities to build up capabilities to better assess, manage and mitigate the impact of these climate risks on their assets,” said MAS.

MAS conducted a study on how much banks and insurers in Singapore are exposed to sectors that would be potentially affected in a disorderly transition to a low-carbon economy.

These sectors are fossil fuel, utility, energy-intensive manufacturing, housing, transport and agriculture.

It found that 30 per cent of bank loans were extended to these sectors, which is similar to the level of exposure for banks in the European Union.

The majority of loans are in sectors with relatively low emissions for every S$1 million of loan. This suggests less susceptibility to impairments from changes in climate policy.

MAS said that there remains significant challenges in estimating the impact of physical risk at this point due to data limitations, as well as the complexity and uncertainty with extreme weather events.

But it added that it is working with other government agencies, and is looking to engage research and educational institutes to better understand the implications of physical risk that banks in Singapore could be exposed to.

CRYPTO ASSETS

Despite rapid growth, crypto-assets remain only a small proportion of overall financial system assets and have not been widely used in critical financial services, said MAS.

But it said that crypto-related activity would continue to grow and be more deeply interconnected with financial institutions.

Hence, crypto-assets and their markets would become significant for financial stability considerations in the future.

When financial markets are under stress, there may be a surge in redemptions for stablecoins, which refer to cryptocurrencies which peg their market value to an external reference such as the US dollar.

This could in turn propagate instability to the wider financial system, said MAS. The likelihood of bank runs may increase if such coins become a widely accepted store of value and as a digital substitute for cash.

“The growth of decentralised finance also has the potential to create a shadow financial system without the regulatory safeguards designed to mitigate financial stability risks across the entire range of financial services. As such, close monitoring of the crypto-asset market will be increasingly important going forward,” said MAS.