Sustainability Stress Testing the Financial System: Challenges and Approaches

Abstract

In addition to risks originating from the economic system, the stability of financial markets and institutions is exposed to adverse conditions in the surrounding social and ecological system. The exposure from unfavorable socio-ecological conditions (sustainability risks) affects the financial markets from multiple perspectives. A way to assess the financial system’s exposure to these risks and also to explore risk mitigation strategies is to incorporate sustainability risks into the framework of stress testing the financial system. This contribution emphasizes directions for the design of sustainability stress test (SST) models for the financial system. The major challenges for conceptualizing an SST framework are related to modeling the sustainability stress factors, their propagation within the financial system and the system’s response. It is argued specifically that the structural pattern of the financial system and its behavioral dynamics have to be considered in a forward-looking way in order to adequately model the SST framework.