Ensuring resilience in the face of uncertainty

The European Central Bank and Bank of England convened experts from 18 countries to address rising financial risks in an increasingly unpredictable global environment. Traditional risk management, built on stable data and historical patterns, struggles as geopolitical shifts, climate change, and technological disruption create non-linear, interconnected threats. Small changes can now trigger disproportionate shocks, challenging banks’ ability to price risk and set aside capital. The conference underscores the need for new approaches to handle uncertainty that defies precise measurement.

The ECB notes significant progress in identifying and quantifying climate and nature risks, using improved tools and data to measure direct economic damage from extreme weather. Banks now better understand how droughts, floods, and other hazards transmit financial risks, such as losses from defaults. Public data sources have expanded, enabling more accurate modelling of physical risks. However, these advances only cover part of the challenge, as many climate risks remain forward-looking and difficult to quantify.

The ECB distinguishes between measurable risks and deeper uncertainties, such as those described by Frank Knight’s concept of radical uncertainty. Known unknowns—risks acknowledged but not fully understood—require scenario analysis and resilience testing. The ECB stresses that while banks have made strides in capturing known climate risks, the next step is addressing what remains uncertain, including tipping points and abrupt transitions.

The ECB calls for a broader conversation about managing uncertainty, moving beyond traditional risk models. It highlights the need to prepare for events once considered remote tail risks, such as cascading supply chain disruptions or sudden shifts in energy markets. The focus shifts from precise forecasting to building adaptable frameworks that can withstand unpredictable shocks in a rapidly changing world.