CH_10_Current_Issues_in_Financial_Markets_HDRJDGFKMW

FRM Part II Exam
By AnalystPrep
Study Notes - Current Issues in Financial Markets
Last Updated: Jul 27, 2023
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Table of Contents
153 - Machine Learning and AI for Risk Management 3

154 - Artificial Intelligence Risk & Governance 12
155 - Climate-related Risk Drivers and their Transmission Channels 28
156 - Climate-related Financial Risks – Measurement Methodologies 36
Principles for the Effective Management and Supervision of
157 - 55
Climate-related Financial Risks
158 - Inflation: A Look Under the Hood 63
159 - The Blockchain Revolution: Decoding Digital Currencies 68
160 - The Future Monetary System 88
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© 2014-2023 AnalystPrep.
Reading 153: Machine Learning and AI for Risk Management
After compl eti ng thi s readi ng, you shoul d be abl e to:
Explain the distinctions between the two broad categories of machine learning and
describe the techniques used within each category.
Analyze and discuss the application of AI and machine learning techniques in the following
areas:
Credit risk.
Market risk.
Operational risk.
Regulatory compliance.
Describe the role and potential benefits of AI and machine learning techniques in risk
management.
Identify and describe the limitations and challenges of using AI and machine learning
techniques in risk management.
Machine learning is a branch of artificial intelligence (AI) that uses algorithms to identify patterns in
a data set and then make decisions, just like humans. It aims to imitate how humans learn, gradually
improving its predictive power and accuracy. Machine learning is premised on the realization that
machines can learn without being programmed to perform specific tasks. Machine learning
algorithms use statistical methods to uncover key insights within a data set and then make relevant
classifications or predictions.
In recent years, machine learning has gained a strong foothold in the financial industry, particularly
banking and insurance. It has been used to decide the amount of money to lend to customers, provide
warning signals to traders, detect fraud, and improve compliance with rules and regulations. T his
chapter explores ways machine learning and AI can improve risk management by leveraging the large
volume of data available. We also look at the core machine learning techniques which can be applied
to improve risk management.
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Machine learning falls into two broad categories: supervised and unsupervised machine learning.
Supervised Learning
Supervised learning is a machine learning technique where models are trained using l abel ed data.
T he goal is to find the mapping function that maps the input variable (X) with the output variable (Y).
Y = f(x)
T he word "supervised" comes from the fact that the algorithms used aren't left to deduce the
relationship between X and Y on their own. Instead, the machine is trained using data that are already
labeled. It's pretty much like providing the machine with some questions that are already tagged with
the correct answers and then asking it to find the answers to untagged but similar questions.
Categories of Supervised Learning
Regression Machine Learning
Regression machine learning is a technique that predicts a single output (dependent variable) value
using training data (independent variables). For example, we can use regression to model the risk of
loan repayment using a range of explanatory variables, including average nonpayment rates,
employment status, credit history, and other outstanding liabilities.
One advantage of machine learning regression over traditional regression is that we can include a
larger number of independent variables that can be discarded automatically if they lack any
explanatory power. For example, LASSO regression eliminates variables with zero regression power.
In contrast, Ridge regression gives lower weights to variables that are highly correlated with other
variables in a model. We can also begin with zero power for all variables and gradually add the
variables found to have explanatory power.
Supervised learning employs a technique known as Principal Component Analysis (PCA) to simplify
complex datasets. PCA is a statistical procedure that transforms potentially correlated variables into
a smaller number of uncorrelated variables called principal components. T he objective of PCA is to
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reduce the dimensionality of the data while retaining as much information as possible.
Consider a scenario where you're modeling credit repayment risk as the dependent variable. Among
the independent variables, you have (I) owns a house, (II) owns a car, and (III) has bank savings. Each
of these variables represents different aspects of a person's financial status and can potentially
influence their credit repayment risk.
In a real-world dataset, there might be many such variables, making the analysis complex and
computationally intensive. T his is where PCA comes in. Rather than working with all these variables
independently, PCA identifies the commonalities among these variables and combines them into a
smaller set of synthesized variables – the 'principal components.'
In our example, PCA could combine the three original variables into a single variable - asset
ownership. T his new variable captures the shared variance among the original variables, thereby
encapsulating the underlying construct of 'financial stability' that they collectively represent. By
doing so, PCA enables a more efficient and manageable analysis without sacrificing too much valuable
information.
It's important to note, however, that the results of PCA must be interpreted cautiously. T he original
meaning of the variables can get lost or distorted in the PCA process, and the principal components
might not always have a clear or intuitive meaning.
Classification
Classification involves grouping data into labeled classes. For example, when modeling the likelihood
of default, we could have two categories: Potential defaulters and non-defaulters. T he model would
then be trained on how to classify the data into one of the two classes in an accurate manner. In
binary classification, the model works with just two labels – 0 and 1 (yes and no). In the case of multi-
class classification, the model classifies data into more than one class.
Unsupervised Learning
In unsupervised learning, models are not supervised or trained using labeled data. Instead, models find
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hidden patterns and insights from the given data without human intervention. T he goal is to identify
previously undetected patterns and discover the internal structure of a data set without predefined
output categories. Unsupervised learning methods are used to perform more complex processing
tasks compared to supervised learning. For example, a bank could create an algorithm to scrutinize
customer accounts and identify those with similarities. T his could help the bank develop a product
that specifically targets those account holders.
Categories of Unsupervised Learning
Clustering
Clustering mainly deals with finding a natural structure or pattern in a collection of raw, unclassified
data. Unsupervised learning clustering algorithms scour the data to identify any notable clusters
(groups).
One area where clustering is applied is the detection of spam emails. If an email looks like others
deemed spam, it is also likely to be spam.
T here are several clustering approaches, but the most popular one is k-means clustering. Under k-
means clustering, the desired number of clusters, k, is predetermined. T he algorithm is then tasked
with clustering the data into the k groups through an iterative process. A larger k means you've got
smaller groupings with more granularity, while a lower k means larger groupings with less
granularity. Iteration is aimed at maximizing the difference in means between determined groups.
Each group or cluster has its own centroid (central focal point). If we have two clusters, A and B,
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and a data point Y is closer to the centroid (mean) of A than B, then Y is put in cluster A.
Dimensionality Reduction
Dimensionality reduction is used to analyze and obtain a better representation of data. T he data set
should have less redundant information at the end of the process, but the important parts may be
emphasized. In practice, this technique is used to hive off a section of a large amount of data for
closer scrutiny.
In addition to supervised and unsupervised machine learning techniques, we have deep l earni ng
and neural network s – other branches of machine learning that can be supervised, unsupervised,
or semi-supervised. T he two are used to model super complex relationships between variables and
ultimately to better mimic human decision-making. A key feature of deep learning is that problems
are modeled in a multi-layer network that is extremely difficult to comprehend. As the input data
progresses through the model, it's combined and recombined to form new factors with weights that
depend on the combinations made in the previous layer. T his leads to output that's essentially been
worked out in a "black box." T his perceived lack of transparency and clarity over decisions made by
the model can complicate risk management and can be a source of risk for firms. T his is an issue that
has widely been mentioned in the digital lending market, where the software used essentially runs
borrower data through a black box to determine whether they are eligible for loans and how much
they should get.
The Application of AI and Machine Learning Techniques
Credit Risk
For a long time, firms relied on classical linear, logit, and probit regressions to model credit risk.
However, in recent years, there's been a realization that AI and machine learning can significantly
improve credit risk management and help firms make better lending decisions. Studies have shown
that credit risk can be modeled more accurately by combining traditional statistical methods of
distress and bankruptcy prediction and neural network algorithms.
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One area where machine learning has proved extremely useful is the credit risk analysis of credit
default swaps. T his is because, in the CDS market, there are many uncertain elements involved in
the determination of the likelihood of a default (credit) event and the estimation of the cost of default
in case a default materializes. In a 14-year study conducted between 2001 and 2014 involving CDSs of
different maturities and rating groups, nonparametric machine learning models outperformed
traditional benchmark models regarding prediction accuracy. T he nonparametric machine learning
models also performed better in terms of suggesting the most practical hedging tools.
Banks are increasingly relying on machine learning to make better consumer and SME lending
decisions.
Market Risk
Market risk emanates from exposure to the financial market, including investing and trading in
various assets such as stocks and bonds. Machine learning has been used in several market risk
management areas:
Stress testi ng mark et ri sk model s to di scover hi dden or emergi ng ri sk s: One
of the risks that come with the use of models to analyze market risk is that such models
can be incomplete, false, invalid, or even incorrectly specified in terms of parameters.
Machine learning can reveal whether the models used have any of these issues. Machine
learning techniques can also be used to scan for unsuitable assets in trading models. For
example, yields.io offers an AI-driven algorithm that provides real-time model monitoring,
model testing for deviations, and model validation.
Understandi ng the i mpact of a fi rm's tradi ng acti vi ti es on mark et pri ci ng: AI
and clustering techniques have been used by large trading firms to look for ways to reduce
transaction costs associated with large trades that have the potential to move the market
price, particularly in illiquid markets.
Provi di ng real -ti me warni ngs to traders: A combination of neural networks and
decision trees can be used to provide traders with real-time warnings of impending changes
in underlying trading patterns.
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Operational Risk
Operational risk concerns itself with risks emanating from both internal and external operational
breakdowns. Such risks are attributable to people (e.g., strikes and go-slows), systems, frauds,
neglected procedures, or natural disasters. In recent years, operational risks have become more
complex and frequent, prompting firms to explore a path toward artificial intelligence and machine
learning-based solutions.
AI and machine learning can help firms to:
Identify, measure, estimate, and assess the impact of operational risk exposures.
Identify effective risk mitigation strategies.
Find instruments that can facilitate shifting or trading risk.
AI and machine learning can be effective tools against fraud. T his happens when firms automate
routine tasks to minimize human error. Besides, machine learning and AI can be employed in
processing unstructured data to screen out relevant content or negative news and evaluate the
extent of interconnectedness among individuals to assess how prone they might be to an external
attack. Further, AI tools can be used to monitor individual traders by combining trade data and their
electronic and voice communications records. Lastly, AI tools can single out alerts that need a more
urgent response.
Regulatory Compliance
Any firm that wants a sound risk management system must comply with all risk management
regulations. To help with compliance, most firms have turned to RegTech – a subset of fintech that
focuses on technologies that can facilitate the delivery of regulatory requirements more efficiently
and effectively compared to the existing traditional capabilities. AI is an excellent RegTech tool
because it allows for continuous monitoring of firm activities. T his way, the firm has access to real-
time insights that help it avoid compliance breaches rather than dealing with the consequences of
breaches after they have occurred.
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Potential Benefits of AI and Machine Learning Techniques in
Risk Management
For risk management, AI and machines offer several key benefits:
Improved data processi ng: AI and machine learning techniques have made it possible to
process structured and unstructured data in massive amounts. Datasets can even be
combined to form new variables that unravel key relationships.
Improved effi ci ency: Automation of repetitive tasks can help firms to reduce costs.
Real -ti me and predi cti ve i nsi ghts: AI and machine learning tools can alert firms about
new exposures faster than traditional tools. In addition, machine learning and AI tools can
increase preventative risk advice and help firms develop faster response times in critical
situations.
Improved deci si on-mak i ng: Machine learning is associated with better decision-making
through greater (predictive) insights and risk visibility.
The Limitations and Challenges of Using AI and Machine

Learning Techniques in Risk Management
Several practical issues plague the use of AI and machine learning techniques in risk management:
Avai l abi l i ty of sui tabl e data: T he effectiveness of AI and machine learning
techniques significantly depends on the availability of suitable data. T hese techniques can
easily read all types of data and process complex information, but the rapid development of
machine learning solutions has outpaced firms' abilities to adequately organize the internal
data they possess. Often, valuable data is stored in separate silos across departments,
sometimes on different systems, creating barriers to accessibility and integration. Internal
political and regulatory issues can also restrict data sharing, further compounding the
problem. Moreover, essential data might not be formally recorded but instead held as
informal knowledge within the firm, making it hard to utilize in AI models. Hence, achieving
optimal results from machine learning for risk management necessitates better data
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organization and accessibility.
Avai l abi l i ty of sk i l l ed staff: T he successful implementation of AI and machine
learning in risk management also hinges on the availability of skilled staff who can
understand and effectively work with these new solutions. A survey of the top 1000 firms
in the United States revealed that their primary concern with AI implementation was the
readiness and ability of their staff (Wilson et al. 2017). T raining a skilled workforce to
proficiently implement and utilize these techniques is a time-consuming endeavor, despite
efforts by some firms to bypass this issue by tapping into regions with a higher prevalence
of these skills, such as India.
Accuracy of machi ne l earni ng sol uti ons: T he actual accuracy of machine learning
solutions raises further concerns. Although the range of testing approaches is expanding,
this expansion is driven by the evident limitations of previous methods and the need to
overcome them. Consequently, firms cannot merely 'apply' a machine learning risk
management solution; instead, it's an ongoing process requiring regular evaluation to
ensure their solution is currently considered best practice. Particularly with AI, where
there's some or complete automation from data gathering to decision-making, the need for
human oversight is crucial. T he case of Knight Capital, whose stock trading automation led
to a loss of $440 million within 45 minutes, illustrates this risk vividly.
Transparency and ethi cs: Lastly, transparency, ethics, and compliance pose significant
challenges in AI and machine learning solutions for risk management. Deep learning
methods, which are gaining popularity, operate on hidden layers between the input data and
output decision, creating a 'black box' system. T his lack of transparency complicates risk
oversight and can lead to regulatory compliance issues, especially when demonstrating
model validity. Convergence of models used by different firms could also induce systematic
risk. On the ethical side, there's a concern that deep learning models might inadvertently
make decisions based on indirect proxies for discriminated-against categories like race,
gender, and sexuality, especially as more atypical data is incorporated into risk
management. Ensuring AI and machine learning techniques adhere to ethical guidelines and
laws becomes increasingly challenging and important.
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Question
In the context of the Credit Default Swap (CDS) market, a financial institution is
contemplating the use of artificial intelligence (AI) and machine learning techniques to
manage its credit risk. Which of the following statements is correct regarding the
application of these techniques?
A. AI and machine learning techniques are best suited for evaluating and improving the
liquidity of CDS instruments in the secondary market.
B. AI and machine learning techniques are primarily useful for enhancing customer
interactions in the context of the CDS market.
C. T he use of AI and machine learning in the CDS market is most valuable for improving
audit trails and ensuring regulatory compliance.
D. Employing AI and machine learning techniques can improve the prediction accuracy of
credit events and default costs in the CDS market.
Sol uti on
T he correct answer is D.
While AI and machine learning techniques can have a range of applications within
financial markets, in the Credit Default Swap (CDS) market specifically, their primary
value stems from their potential to handle the complexity and uncertainty of assessing
credit risk. T hese technologies, particularly models involving deep learning, can enhance
the prediction accuracy of credit events (i.e., the likelihood of a default) and the
estimation of default costs. T his predictive capability is vital for managing risk and making
informed investment decisions in the CDS market.
Options A, B, and C, although plausible applications of AI and machine learning
techniques, don't directly address the key challenges inherent in credit risk assessment
within the CDS market. T herefore, option D is the most likely correct answer.
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Reading 154: Artificial Intelligence Risk & Governance
Identify and discuss the categories of potential risks associated with the use of AI by
financial firms and describe the risks that are considered under each category.
Describe the four core components of AI governance and recommended practices related
to each.
Explain how issues related to interpretability and discrimination can arise from the use of
AI by financial firms.
Describe practices financial firms can adopt to mitigate AI risks.
AI risks refer to the potential ills that may cause harm to organizations, consumers, or society at
large. Such risks may originate from:
Data used to train the AI system.
Usage of the AI system.
Poor governance of the system.
According to the Artificial Intelligence/Machine Learning Risk & Security Working Group (AIRS),
potential risks of AI can be categorized into data-related risks, AI/ML attacks, risks related to testing
and trust, and compliance (people) risks.
Data Related Risks
a. Learni ng Li mi tati ons
T he effectiveness of any AI/ML system depends on the data used to train it and the scenarios
considered during the training. Sadly, training the system on all possible scenarios and data is not
always possible. For example, if we were to develop a model that seeks to predict the occurrence of
a major financial crisis, we would only have data gathered from past crises. Even then, history shows
that past financial crises were not preceded by the exact same conditions or scenarios. T here have
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always been unique situations and “surprise” factors. In the end, we would develop a model that
enjoys a certain degree of accuracy, but it would be far from perfect.
T herefore, learning limitation is a key issue that’s often discussed during risk reviews and
brainstorming sessions that precede the deployment of an AI system.
b. Data Qual i ty
Poor data quality limits the learning capacity of AI/ML systems leading to inaccurate or unreliable
output. Furthermore, poor data quality also negatively impacts future decisions and inferences. Poor
data may lead to inaccurate predictions and even failure to achieve the intended objectives.
Potential AI/ML Attacks
Potential attacks against AI/ML systems include the following:
a. Data Pri vacy Attack s
If an attacker is able to infer the data used to train the AI/ML system, they may gain access to
sensitive data used to train the model, thereby compromising the privacy of the system as a whole.
We have two major types of data privacy attacks: membership inference and model inversion
attacks.
In a successful membership inference attack, an attacker is able to determine whether a particular
record is present in the training data set. T hey are able to determine, with a certain degree of
confidence, whether a certain input or set of inputs was part of the data used to train the system. On
the other hand, in a model inversion attack, an attacker is able to extract representations of training
data. T hey usually achieve this by reconstructing training data from model parameters.
b. Trai ni ng Data Poi soni ng
Data poisoning refers to the contamination of the data used to train the AI/ML system.
Data poisoning may increase the error rate and thus negatively impact the learning process and the
overall output. "Label-flipping’’ and "frog-boil’’ attacks are examples of attacks under this category.
c. Adversari al Inputs
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Some AI systems use inputs from external systems or users. T hese AI systems interpret such input
and undertake some actions, such as classifying the data. An adversary could potentially deploy
malicious algorithms designed to bypass the AI system classifier. Most adversarial attacks usually aim
to deteriorate the performance of classifiers on specific tasks by essentially “fooling” the machine
learning algorithm. Such malicious inputs are referred to as adversarial inputs.
d. Model Extracti on
In a model extraction attack, a malicious user attempts to steal the model itself. T he adversary first
accesses the prediction API of the target model and then queries to extract information about the
model’s vital components. T he goal is to use this information to gradually train a pseudo model that
works pretty much like the target model. Attempts can then be made to sell the pseudo model. In
some cases, the adversary may take time to study the model even more closely with the aim of
launching further attacks on the parent AI system.
Testing and Trust Risk
One of the trickiest aspects of AI/ML systems is that some issues do not come to light in the early
stages of implementation. Rather, these issues become apparent after continued use. T he AI/ML
system might also evolve and generate complexities that might worsen over time. Here are potential
concerns related to testing and trust risk:
a. Incorrect Output
Certain AI/ML systems are inherently dynamic and prone to changes over time. In particular, the
output may evolve over time and differ significantly from the output produced in the early stages of
implementation. T his poses a real challenge to the testing and validation of the AI/ML system. It may
not be possible to carry out reliable tests for all the scenarios, combinations, and permutations of
the available data.
b. Lack of Transparency
Although AI/ML systems have been with us for a while, they have still been considered an emerging
technology with which most people are not yet fully conversant. Some people have a very different
understanding of how these systems work, a situation that has led to persistent trust issues. It is
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believed, for example, that AI systems work out problems in a ‘’black box’’ that isn’t open to
scrutiny.
c. Bi as
AI bias refers to injustice or unfairness against a person, entity, or corporation. Evidence shows that
AI systems usually churn out biased outcomes that can have serious negative effects on individuals
and organizations. Technologies are not neutral; they are only as good (or bad) as the people who
develop them. For example, in 2014, software engineers at Amazon developed an employee
recruitment program that used the applicants' resumes as input. However, the program was found to
be biased against women for technical roles. T his discrimination forced the company to retire the
program prematurely.
Biased AI outcomes can also lead to legal, regulatory, reputational, and operational risks.
Compliance
a. Pol i cy Non-compl i ance
As the implementation of AI continues apace in the financial industry, there is a need to consider its
effects on the existing internal policies. Indeed, regulatory authorities have expressed a lot of
interest in AI, and multiple working groups have been formed to discuss supervisory challenges
posed by emerging technologies. T his has led to a trove of guidelines, white papers, and surveys on
the subject as regulators seek to lay bare all the emerging challenges and how they impact their
work.
The Four Core Components of AI Governance
As the use of AI becomes more widespread within the financial industry, there’s a general consensus
among regulatory bodies and individual firms that there’s a need to keep a close eye on AI emerging
risks. However, there’s also an acknowledgment that there are multiple ways to govern these risks.
Each firm should be allowed to develop or modify its own risk management framework to recognize
these risks. T here are four key components of AI governance: definitions, inventory,
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policy/standards, and framework, including controls.
Definitions
Definitions of AI/ML may vary from one organization to another depending on the organization’s
culture, environment, and adoption. T he first step toward sound and robust AI governance should
include a clear definition of what constitutes AI (and what doesn’t). T his definition is vital since it
provides the foundation and a clear understanding of the other AI governance components.
For the best results, AI definitions should include the following:
All the techniques an organization uses to train and develop AI.
T he features that distinguish AI from traditional rule-based systems.
T he implications of each definition.
T he definitions and the supporting documentation should also clearly indicate how an organization’s
stakeholders identify with the AI definitions. Such stakeholders include senior management, system
developers, and legal, compliance, and information security officers.
Inventory
An AI inventory is simply a centralized repository that helps an organization keep track of all AI
systems in use and monitor associated risks. An inventory describes the role of each AI system
deployed, its uses, and any restrictions on such use. Inventories can also provide a list of data
elements that constitute each AI/ML system.
Policies
In some cases, the use of AI systems can be governed on the basis of existing policies and standards.
However, there may be a need for the formulation of new policies and standards or some
modification of the existing ones to ensure that AI is deployed appropriately.
It’s difficult to discuss AI policies and standards without mentioning ethical principles and accepted
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norms. It should be noted that ethical principles for AI have been discussed in the financial industry
for a long time. As a result of these discussions, the financial industry has developed a binding set of
principles. Indeed, some institutions have gone as far as publicizing the principles by which they
abide. T hese principles have had positive impacts on organizations and should therefore be developed
further.
Framework
A robust AI governance framework is important as it helps organizations learn, govern, monitor, and
develop the AI system. T he first part of an AI governance framework might involve the identification
of key stakeholders, formalized in the Center of Excellence (CoE), working group, or council. T he
stakeholders for various groups and departments collectively form what we call a ‘coalition.’ With
such groups, best practices, sharing of knowledge, and guidance on the use of AI systems can be
achieved. Such efforts, in most cases, bear fruits when close links are established with technology,
data engineers, and business line stakeholders.
In reviewing an AI-enabled initiative, the ‘coalition’ should consider the following:
Data ethics.
Privacy rights.
Suitability of the training data used.
Safety of the dataset.
Supervisory roles.
Data development (whether internal or external).
It should be noted that identifying the potential AI/ML risks helps formulate an operational risk and
control framework. Once potential risks have been identified, a gap analysis can be established
against existing controls. T he number of participating control owners depends on an institution’s
control library. T horough planning and a structured approach are necessary to achieve the gap
analysis. T he gap analysis results are then used to create new or improved controls to mitigate the
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identified AI/ML risks.
Other factors to be considered under the AI framework include:
Monitoring and Oversight
A central monitoring process is important since it provides exposure to the decisions made and the
opportunity to raise concerns or challenges appropriately. It is, therefore, necessary that the
structure considers the changing needs of an organization as the adoption of AI matures or as changes
occur in the industry. Some firms believe that monitoring and oversight procedures already in place
sufficiently address potential AI risks.
In most cases, existing governance is designed for scenarios where the degree of human involvement
is high. T he accuracy, consistency, and efficiency of the existing processes may be improved by
reducing or removing interventions.
Third-party Risk Management
When deploying an AI/ML system, an organization may involve a dedicated third party who has the
knowledge and expertise required to pull off a successful launch. Such a move also enables
scalability, increased computing power, and increased access to vendors within the larger fintech
system. It is, therefore, necessary that firms strengthen the capabilities of their third-party risk
management (T PRM). In some cases, institutions may include third-party contractual clauses with
respect to the testing methodology of the AI system.
Three Lines of Defense
A three-line-of-defense model includes:
The fi rst l i ne: Responsible for business risk.
The second l i ne: Responsible for risk oversight and independent challenge.
The thi rd l i ne: Tasked with independent assurance through the internal audit function.
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Roles and Responsibilities
An AI framework should clearly define the roles and responsibilities of various parties within the
organization. T he following are examples of roles and responsibilities usually considered within an AI
framework:
Party Role
Ethics Review Board Ensures that all AI projects observe
the organization’s norms and principles.
Center of Excellence Works across business units or product lines
(CoE) to provide expert knowledge or training while
also keeping in touch with industrial developments.
Data Science Building and running AI algorithms
and monitoring the system.
ML Operations Data creation and documentation.
Interpretability and Discrimination
Interpretability refers to the presentation of the AI system results in a format that a human can
understand. On the other hand, discrimination refers to an unfairly biased outcome. T he two form a
major part of the risk management framework for any organization deploying an AI/ML system. Let’s
see the potential risks associated with each.
Discrimination in AI
AI may lead to a discriminatory and unfairly biased outcome if not implemented appropriately.
Sources of such poor implementation include biased data, poor AI system training, or the use of
alternative AI systems or data sources that could potentially be used to generate better outcomes for
certain disadvantaged groups. An AI system that may cause unfairly biased outcomes is likely to cause
regulatory non-compliance issues and legal and reputational risk.
Existing Legal and Regulatory Framework
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Discrimination in areas that affect our day-to-day life, e.g., housing, lending, etc., is prohibited by both
federal and state statutes.
According to federal banking regulators, discrimination can be of three types: overt discrimination,
disparate treatment, and disparate impact.
Overt di scri mi nati on occurs when an AI system openly or actively discriminates. For example, a
lending model might be designed to give people from certain regions instant “free” points even
before the rest of their data has been considered. T he key issue here is that the model is obviously
or blatantly providing or offering more favorable terms to one group at the expense of another.
However, overt discrimination doesn’t have to be intentional. For example, a loan department might
come up with a product that can only be accessed by applicants above a certain age but, in so doing,
lock out younger applicants who may well have attained the legally accepted age.
Di sparate treatment di scri mi nati on is the treatment of members of a protected class
differently from members of an unprotected class. In the context of AI lending, it occurs when a
model treats an applicant unfairly compared to other applicants based on the applicant’s personal
characteristics, e.g., race, gender, or sexual orientation. In an AI system, a good example would be
when an insurance company uses an AI model that favors white over black people when assessing
eligibility for coverage. It should be noted that a system could be statistically sound but not legally
non-discriminatory.
Di sparate i mpact di scri mi nati on occurs when an AI system uses a neutral factor to make a
decision that affects a protected class more than an unprotected class. For example, a lending model
might give a loan to an applicant from a majority-white zip code while turning down a similarly
situated applicant from a majority-black zip code. T he neutral factor here is the zip code.
Data as a Cause of Discriminatory AI
Input data may lead to AI-related illegal discrimination in several ways:
If it identifies or closely proxies class membership.
If it causes protected class members to experience less favorable outcomes.
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If it has features that skew predictions for the protected class.
T raditional data inputs, for example, credit bureau attributes, have a lower probability of causing
disparate impact. T his is because they are thoroughly vetted prior to approval and publication for use
by lenders. On the other hand, non-traditional data, for example, rental payments, may raise more
disparate impact concerns as compared to traditional data. Such data usually raises coverage and
accuracy concerns.
Algorithms as a Cause of Discriminatory AI
T he complexity and opacity of algorithms may lead to discriminatory outcomes. Algorithms may
create interactions between variables and non-linear relationships that are too complex for humans
to understand. Such relationships may cause disparate treatment by creating proxies for protected
class status. However, some of these concerns have been addressed by the use of AI methods that
allow for a comprehensive understanding of such complex relationships.
System misspecification may also lead to discriminatory outcomes. In this case, prediction features
for both outcome and protected class status may be independent, but the class effect is included in
the prediction.
As an example, assume that a lending model takes a loan applicant’s shopping habits into account,
particularly whether they buy goods at a discount store. At first thought, this might look like an
objective variable because it can reasonably be viewed as a measure of wealth and, therefore, a
predictor of repayment. But if the system goes ahead to capture the store’s location, it may
unintentionally capture a race effect because different neighborhoods have different racial makeups.
In this scenario, shopping as a variable may serve as a proxy for the neighborhood, which in turn acts
as a proxy for race.
Interpretability/Explainability
Inconsistent Explanations
Unlike traditional linear systems, the same training data may be used for training multiple AI/ML
systems. Although the output from such systems is likely to be similar, each model is likely to have a
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unique logical explanation as to how the AI output was generated. T he presence of different logical
explanations for the same outcome can ignite debate and serious discussions among the system’s
developers and monitoring teams.
Interpretability methods enhance human understanding of the AI/ML system, which helps mitigate
risks associated with the use of AI/ML systems.
Detection and Appeal of Incorrect Decisions
At the core of most AI/ML systems lies probabilistic tools that help the system make decisions based
on the likelihood of each set of events. But this means the system may make incorrect decisions
because the probability is not predictable. Even if the system shows there’s a 50% chance a
borrower will default, there’s simply no way to accurately predict the outcome. T he variables
considered when computing the probabilities also play a big role in all this. T he more unrealistic such
variables are, the more likely it is to end up with an incorrect decision.
In some more complicated systems, neither the developer nor the user has a clear understanding of
the decision made or whether it is right or wrong. T hus, the interpretability of high-impact AI/ML
decisions is a huge source of risk. If there are doubts over the correctness of an AI-driven decision
that has a major impact on individuals or the organization as a whole, there will be attempts to
improve the model or even replace it entirely to mitigate the effects.
Security Audit
Malicious actors could potentially misuse AI/ML. Interpretability is vital in ensuring that AI/ML
systems are protected as security evolves in the AI/ML world. T he red team or white-hat hacking
audits in testing AI/ML systems may apply post hoc explanation techniques in attacks against AI/ML
systems.
Regulatory Compliance
Several legal regulations may require the use of interpretable systems, post hoc explanations, and
the documentation they facilitate. Such legal regulations include the Equal Credit Opportunity Act,
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the Fair Credit Reporting Act, and the EU. General Data Privacy Regulation and so on.
Common Practices to Mitigate AI Risk
To mitigate AI risk, there are three main areas of interest: the trai ni ng data, the l earni ng
procedure, and the output predi cti ons. T his gives rise to three corresponding risk management
approaches: pre-processi ng, i n-processi ng, and post-processi ng approaches. Post-processing
approaches are suitable for runtime environments since they do not necessarily require access to
the training data. Furthermore, post-processing approaches operate in a black-box environment,
meaning that they don’t need access to the internals of models. T hus, they can be applied to any
machine learning model.
Oversight and Monitoring
Oversight Processes
Oversight of an AI system capped by intensive monitoring to validate various aspects of the system
helps ensure the accuracy and efficiency of the system. An oversight process can begin with the
creation of an inventory of all the AI systems at a given institution, the uses of the system,
techniques employed, developers’ names, and risk ratings. T he evaluation includes assessing the
inputs, outputs, and the AI system itself. Assessing training data is important for ensuring data quality
as well as identifying potential biases that the data may contain. To evaluate the AI system, it is
benchmarked against optional models and known methods are utilized to ensure the interpretability
of the model.
Monitoring for Drift
Drift may result in a number of errors and risks in AI systems. Detection of drift can help mitigate
some AI-based risks. Monitoring helps to provide insight into the ‘‘accuracy drift’’ of the model by
estimating the accuracy of the model. Monitoring also helps to provide insight into the “data drift” by
checking for the deviation of the input data from the training data.
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Accuracy drift could worsen your model, while data drift, on the other hand, helps businesses to
understand the change in the characteristics of the data at runtime.
Addressing Discrimination in AI
T he review of input variables and systems for evidence of discrimination in most lending
organizations is done by compl i ance, fai r l endi ng, and system governance teams.
Technological advances can enable the automation of most of these tasks. Nevertheless, a human-
centric approach may be required for a fair AI. It is not possible for an automated process to fully
substitute the experience and knowledge of a well-informed team reviewing the AI system for
discrimination bias. T herefore, it is important that the first line of defense against discrimination in
AI should include some manual review.
A number of recently researched algorithms have proven to reduce class-control discrepancies
while maintaining the predictive quality of the system. In order to reduce these discrepancies, the
mitigation algorithms find the “optimal” system for a corresponding quality and measure of
discrimination.
Variables that cause discrepancies are excluded from the systems. Other tested variables are used in
their places. However, these methods have been shown to have low rates of success in complex
AI/ML systems.
More recently developed approaches for minimizing discrimination involve engaging in data
processing, making decisions within the algorithm, and carrying out post-processing on the output.
Enhancing Interpretability and Explainability
Ensuring Quality Explanations
One of the major challenges to many institutions is ensuring that the explanations of AI/ML are
reliable and useful. Rough estimates and inaccurate or inconsistent explanations in financial service
institutions, for example, raise special concerns, especially for credit lending decisions.
To reduce explainability-based risks, institutions may test the explanatory techniques used for
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accuracy and stability on the simulated data.
Potential Risk Mitigation
Malicious actors could use available AI system explanations and predictions to attack an organization.
Organizations can mitigate such potential risks by only sharing the required information. For
instance, an institution may only share information that a given consumer requires. Similarly, a firm
should strictly share information whose dissemination is legally required.
Strong traditional technology and cyber control could be used for effective AI-based risk mitigation.
T he use of strong information security practices and watermarking could help mitigate model
extraction attacks. Watermarking involves training the AI/ML system to produce unique output for a
given input.
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Practice Question
A financial firm has deployed a sophisticated AI system for credit scoring. Recently, the
firm's IT department detected anomalous system behaviors. T he anomaly report showed
that certain borrowers' credit scores had been unusually boosted during the model's
retraining phase. On further investigation, it was found that the scores were manipulated
through the subtle addition of incorrect labels to the training data. T he IT department
suspects an orchestrated attack to distort the system’s learning process. Which of the
following potential AI/ML attacks is the firm most likely experiencing?
A. Membership inference attack
B. Model inversion attack
C. T raining data poisoning attack
D. Adversarial inputs attack
T he correct answer is C.
T raining data poisoning attack typically involves the contamination of the AI/ML system's
training data in a way that negatively influences its learning process or output. In the
given scenario, incorrect labels were subtly added to the training data during the model's
retraining phase. T his is a clear indication of a T raining Data Poisoning Attack aimed at
manipulating the system's learning process and consequently altering the borrowers'
credit scores.
Opti on A i s i ncorrect because a membership inference attack focuses on an
attacker's attempt to ascertain whether a specific record was included in the training
data set used for the AI system. In the scenario provided, there's no indication that such
an inference is being made; the problem revolves around the manipulation of training
data, not the disclosure of whether certain records were included in the training set.
Opti on B i s i ncorrect because a model inversion attack involves an attacker
extracting specific information about the training data directly from the model. While this
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type of attack also concerns the training data, the scenario described does not involve an
extraction of data from the model, but rather a manipulation of the labels within the
training data to distort the AI system's learning process.
Opti on D i s i ncorrect because an adversarial inputs attack typically involves the
intentional provision of malicious inputs designed to bypass the AI system's classification
or decision-making mechanisms. In the presented scenario, the problem is not related to
the input data being used by the AI system after its training but rather pertains to the
alteration of the training data itself.
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Reading 155: Climate-related Risk Drivers and their Transmission
Channels
Describe climate-related risk drivers and explain how those drivers give rise to different
types of risks for banks.
Compare physical and transition risk drivers related to climate change.
Assess the potential impact of different microeconomic and macroeconomic drivers of
climate risk.
Describe and assess factors that can amplify the impact of climate-related risks on banks as
well as potential mitigants for these risks.
Climate-related Risk Drivers
Climate-related risks refer to climatic changes that could potentially give rise to financial risks.
T hese risks have increased significantly over the last 100 years due to global warming, which has, in
turn, increased the frequency of extreme weather events. T he result is loss of lives, diminished
livelihoods, reduced production in plants and animals, and damaged infrastructure, among other
adverse impacts.
Climate risk drivers can be grouped into one of two categories:
Physical risks.
T ransition risks.
Physical Risks
Physical risks are tied to weather and climatic changes that impact the economy. T hey can be
subdivided further into acute ri sk s, which come about due to extreme weather events, or chroni c
ri sk s associated with long-term progressive shifts in climate. Acute physical risks include wildfires,
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heatwaves, floods, storms, hurricanes, typhoons, and cyclones. Chronic physical risks include rising
sea levels, ocean acidification, and rising temperatures. Prolonged periods of high temperatures can
also lead to desertification.
Physical climate risks may occur with a significant time lag. What's more, severity differs from one
event to another. Human activity and day-to-day decisions, to an extent, affect exposure to physical
risks. Nevertheless, it's impossible to control the location, timing, and magnitude of specific physical
events.
Transition Risks
T ransition risks refer to societal disruptions arising from adjustments towards a low-carbon
economy. Migration to a low-carbon economy comes with a host of changes that impact not just
working conditions but also the products manufactured.
Sources of transition risk include:
Changes in public sector policies.
Innovation and modifications in the affordability of existing technologies (e.g., that make
renewable energies cheaper or allow for the removal of atmospheric GHG emissions).
Investor preference for greener tools and resources.
Banks have been caught up in these risks, a situation that has given them the incentive to deploy risk-
monitoring tools in an attempt to mitigate or eliminate risk effects. However, the sheer scale and
synchronous nature of transition-related changes mean it isn't easy to keep up, and the impact can be
greater than previously anticipated. It is noteworthy that transition risk drivers vary from one
economy to another depending on the existing levels of technology and mechanization.
Let's now briefly look at examples of transition risk drivers.
Climate Policies
In recent years, countries worldwide have put a lot of effort toward finding solutions to risks
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resulting from climate change. T hrough the Paris Agreement, an international treaty that enjoys the
support of 191 countries (and the European Union), nations have pledged to take a host of measures
and enact policies that reduce GHG emissions and adopt low-carbon economies. Some countries have
gone as far as barring the importation of certain products while setting deadlines for the manufacture
of certain local goods. For example, the UK has pledged to reduce greenhouse gas emissions by at
least 100% of 1990 levels (net zero) by 2050.
Technology
T here's been a sustained push around the world to replace old technology with new technology and
tools that emit little greenhouse gases. For example, counties are encouraging automobile producers
to ditch the production of gas-dependent cars in favor of electric models, which emit less carbon into
the atmosphere. T he problem is that some of the proposed technological changes might force
companies to ditch proven long-term business models and adopt the use of resources that may
become more expensive over time. On the upside, firms that are quick to adopt the changes stand to
benefit from public goodwill and favorable government policies. T he government can also impose
taxes on the use of certain resources.
Investor Sentiment
Investors are increasingly factoring climate risks into their investment decisions, a trend that may
reflect pressure from non-governmental organizations and environmental groups. Indeed, some of
the world's largest asset managers are already incorporating climate change into investment decision-
making and investment approaches. For corporations directly impacted by climate change, both their
bond and equity offerings will be subject to valuation and re-valuation as investors change their
assessment of the underlying climatic risks.
Consumer Sentiment
Adapting to a low-carbon economy requires a change in human behavior. Climate-friendly
consumption would, for example, lead to more climate-friendly transportation, manufacturing, and
energy use. Evidence indicates that there is a shift in consumer behavior already underway. Clients
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of retail banks may ask that their savings or investments be directed to institutions with more eco-
friendly policies or projects that contribute to the environment. A growing awareness of, and
explicit demand for, climate-friendly financial products and investment could spur corporations and
banks to change their business strategies, notwithstanding potential regulatory or supervisory
approaches. In the same vein, investors' and consumers' expectations of hazards (e.g., flooding),
climate policies, or technological changes may lead to changes in their preferences and consequently
impact the price of assets.
Assessing the Potential Impact of Different Microeconomic

and Macroeconomic Drivers of Climate Risk
T here's a clear link between climate risk drivers and financial risk for banks. T he causal chains
linking climate risk drivers to the financial risks the banking sector faces are known as
transmi ssi on channel s. Put differently, transmission channels present the avenues through
which climate change can expose banks to financial risk. T hese transmission channels can either be
macroeconomic or microeconomic.
Microeconomic Channels
Mi croeconomi c transmi ssi on channel s refer to the causal chains by which climate risk drivers
affect various individual counterparties doing business with banks, potentially exposing banks and the
entire financial system to climate-related financial risk. T hey include the direct effects of climate
change on banks, particularly events that disrupt operations and the ability of banks to raise funds for
day-to-day business. In addition, they include the indirect effects on name-specific assets such as
bonds, single-name CDS, and equities.
Macroeconomi c transmi ssi on channel s are the avenues through which climate risk drivers
affect macroeconomic factors such as inflation, labor productivity, GDP, and economic growth.
T hese factors may, in turn, have an effect on the economy in which banks operate.
T he following are various microeconomic transmission channels and the financial risk they create:
Credit Risk
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Households
Severe weather can damage bank-funded property. T his, in turn, increases the probability
of default non-performing asset ratios and lowers bank equity ratios.
Banks using residential real estate as collateral for mortgages may see their credit risk
increase if such property is damaged by adverse weather or rising sea levels.
Corporates
T here's evidence that severe weather events (physical risks) reduce corporate
profitability and potentially increase credit risk to lenders.
Agricultural entities funded by banks can be hit by high temperatures and precipitation,
leading to low yields and problems repaying debt.
Sovereigns and Subnational Institutions
Physical risk events may lead to lower tax revenues for sovereigns and supranational
institutions resulting from impaired corporates, reduced household income, and an overall
reduction in output. T his, in turn, increases the risk of default and the loss given default for
banks with sovereign and municipal exposures.
Government Policy
T ransitioning toward a low-carbon economy may lower the productivity and profitability of
corporates, affecting their creditworthiness.
Technological Change
Carbon-intensive technologies may be subjected to heavy taxation to discourage their use.
T hus, any firm that continues to rely on such technologies may find itself unable to
compete against those that quickly adopt newer, more efficient technology. Credit-related
losses may be higher for banks exposed to companies that cannot adapt to carbon-neutral
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economies.
Sentiment
As more and more consumers embrace less carbon-intensive products, producers that stick with the
high GHS emission products may see a decline in sales. As such, banks exposed to such producers
may see an increase in credit risk.
Market Risk
Physical and transition risks can alter or reveal new information about future economic
conditions that will affect the price and value of financial assets. T his may result in
downward price shocks and an increase in market volatility.
Climate risk could also lead to a breakdown of long-established correlations between
financial assets. T his would render hedging methods ineffective and reduce the ability of
banks to manage their market risks.
Liquidity Risk
Banks' liquidity risk may be affected directly as a result of climate risk drivers, either
through their ability to raise funds or liquidate assets or indirectly as a result of customer
demands liquidity.
Households and corporations affected by physical risks may withdraw deposits or borrow
funds to cover recovery and other cash-flow needs. Such actions may put a bank under
unprecedented liquidity pressure for banks.
Operational Risk
Physical Risk
Banks' operational ability may be reduced if physical hazards destroy transportation and
communication infrastructure.
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Banks and corporations may also see increased legal and regulatory compliance risks
resulting from transition risks.
Macroeconomic Channels
When considering macroeconomic factors, climate risk is expected to have the greatest impact on
credit and market risks.
Credi t ri sk : First, there is likely to be a climate-related increase in human mortality, a
situation that may result in reduced labor productivity. Second, empirical evidence suggests
climate risk has pushed the cost of debt up by 117 basis points in developing countries.
T his means the affected industries may find it difficult to recover from disasters and honor
their financial obligations with counterparties, including banks. In addition, increased
borrowing costs could bring about higher taxes, lower government spending, and reduced
productivity levels, all of which may indirectly impact the credit risk for banks.
Mark et ri sk : At this point, there's little research that seeks to establish how the
interaction between macroeconomic factors and climate-related risks can affect the
market risk for banks. However, some evidence suggests that changes in government
policy might affect the value of assets in certain industries that significantly contribute to
the overall economy.
Factors That Can Amplify the Impact of Climate-related Risks

on Banks
T he following factors can amplify the impact of climate-related risks:
Risk Drivers Interactions
Interactions exist across both physical and transition risk drivers. One area where we've seen such
interactions is the simultaneous introduction of climate-mitigating policies (e.g., preference for
electric vehicles over those that use gas) and technological breakthroughs.
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Financial Amplifiers
Certain financial amplifiers have the potential to increase the impact of climate-related financial risks
on banks. T he materialization of climate-related risks on bank balance sheets might be amplified by
behavioral choices within the financial system and interactions with the real economy. A good
example of a financial amplifier is the absence of insurance or its unaffordability. If bank-funded
assets aren't insured, damage caused by climate-related events could result in a loss for the bank and
result in a difficult recovery plan for the borrower.
Multiple Channels
Some risk drivers may impact banks through more than one transmission channel, a situation that
amplifies climate-related financial risks. Notably, the interaction between microeconomic and
macroeconomic transmission channels can worsen an already dire situation. An example of this
would be where a physical risk results in the destruction of houses, thereby affecting the
creditworthiness of a bank's customers while also impacting the aggregate credit risk for banks.
Mitigants
Mitigants can mitigate and offset banks' exposure to climate-related financial risks through proactive
and reactive actions. Proacti ve acti ons are the pre-emptive steps banks take to reduce their
vulnerability to climate-related risks. Good examples would be diversification and strategic asset
allocation. A bank might increase investment in sustainable companies, particularly those that have
embraced less carbon-intensive business practices and technology.
Reacti ve acti ons include actions taken as a response to climate risks already embedded in balance
sheet exposures. T hey include insurance and reinsurance, hedging, securitization, and asset sales
that enable a bank to reduce its exposure to high-risk assets.
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Question
Consider a multinational corporation, EarthSpan Inc., which has its manufacturing units in
a coastal region prone to cyclones and its largest consumer base in a highly developed
country committed to implementing stringent green policies. Given the company's
present context, EarthSpan Inc. faces an assortment of climate change risks. As a risk
manager, you've been asked to analyze these risks. Which of the following combinations
accurately describes the physical and transition risks EarthSpan Inc. may encounter?
A. Physical risk: Reduction in consumer demand due to changing preferences; T ransition
risk: Infrastructure damage due to cyclones.
B. Physical risk: Damage to manufacturing units due to cyclones; T ransition risk:
Technological obsolescence due to shifting renewable energy technology.
C. Physical risk: Technological obsolescence due to green policies; T ransition risk:
Rising sea levels affecting manufacturing units.
D. Physical risk: Decrease in investor interest due to climate concerns; T ransition risk:
Flooding of manufacturing units.
Solution
T he correct answer is B.
Physical risks associated with climate change relate to changes in weather and climate
patterns that directly affect economies and organizations. EarthSpan Inc., having its
manufacturing units in a cyclone-prone region, faces a physical risk of infrastructure
damage due to cyclones. T his risk, categorized as an acute physical risk, is derived from
extreme weather events.
T ransition risks are those that arise from the societal shift towards a low-carbon
economy. T hese risks encompass changes in technology, policy, and societal behavior
towards a more eco-friendly stance. With its largest consumer base in a country
implementing stringent green policies, EarthSpan Inc. could face a transition risk of
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technological obsolescence, as the shift towards renewable energy technology may
outdate their current manufacturing processes.
Opti on A i s i ncorrect because it incorrectly identifies a reduction in consumer
demand due to changing preferences as a physical risk. In reality, this would fall under
transition risk, as it reflects changes in consumer behavior driven by evolving societal
sentiments and preferences. In the same vein, infrastructure damage due to cyclones is
actually a physical risk as it pertains to the impact of extreme weather events on the
organization's physical assets.
Opti on C i s i ncorrect because it misclassifies technological obsolescence due to
green policies as a physical risk. Technological obsolescence is a transition risk, as it
arises from changes in technology and regulations related to the transition to a low-
carbon economy. Rising sea levels affecting manufacturing units, on the other hand, is a
physical risk, as it pertains to the direct impact of climate-related changes on the
organization's physical infrastructure.
Opti on D i s i ncorrect because it incorrectly identifies a decrease in investor interest
due to climate concerns as a physical risk. T his is actually a transition risk, as it relates
to changes in investor sentiment and their assessment of the organization's exposure to
climate-related risks. Flooding of manufacturing units, however, is as a physical risk, as it
pertains to the direct impact of climate-related events on the organization's physical
assets.
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Reading 156: Climate-related Financial Risks – Measurement
Methodologies
Describe the main issues in identifying and measuring climate-related financial risks.
Identify unique data needs inherent in the climate-related risks and describe candidate
methodologies that could be used to analyze these types of data.
Describe current and developing methodologies for measuring climate-related financial
risks employed by banks and supervisors.
Compare and contrast climate-measuring methodologies utilized by banks, regulators, and
third-party providers.
Identify strengths and weaknesses of the main types of measurement approaches.
Assess gaps and challenges in designing a modeling framework to capture climate-related
financial risk.
Main Issues in Identifying and Measuring Climate-related

Financial Risks
In this section, we discuss general issues in measuring climate-related financial risks and the
translation of underlying concepts to concrete climate risk measurement. Climate change may cause
both economic and financial effects, which may lead to losses for banks. As a result, banks should
have a risk management framework that identifies and measures climate risk drivers, maps and
measures climate-related exposures, identifies areas of risk concentration, and converts climate-
related risks into quantifiable financial risk metrics.
An overview of measurement methodologies that banks and supervisors are currently applying is
discussed here based on conceptual issues related to climate-related financial risk measurement.
Methodological Considerations
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According to BCBS (2015), effective risk governance involves mapping and measuring risk
exposures. T he assessment of climate-related financial risks is similar to that of any other risk. T he
only difference is that climate-related financial risks have unique features that challenge traditional
risk measurement.
Conceptual Considerations in Measuring Climate-related Financial

Risks
As risk managers assess climate-related financial risks, they learn new concepts. T hese concepts are
heavily used in mapping and measuring climate-related financial risks. T he following are some key
concepts supervisors and banks need to know:
Physical and Transition Risk Measurement Considerations
Climate-related financial risks have several unique characteristics. Physical risks and transition risk
drivers drive these characteristics, resulting in different exposure mapping and measurement
approaches.
Generally, physical risk drivers (physical hazards) can be associated with financial exposures using
damage functions that show how a specific risk driver affects tangible assets. We can attribute
disruptions to assets, activities, and related financial flows to comprehensive risk models that
measure financial risk parameters.
T he damage function applied within a specific risk model depends on a bank's technological and
resource capacity, the availability of relevant data, and the purpose for which the estimation is
intended. In addition, sectors, the severity of hazards, time horizon factors, and geospatial
idiosyncrasies determine specific damage functions.
As a result of their distinct characteristics, physical and transition risks are assessed separately.
Some climate change features, however, increase the probability of dependence among these risks.
Hence, they can be viewed jointly.
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Exposure Granularity
Bank's transactions with other parties may expose it to climate-related financial risks. Banks and
supervisors will have to decide the level of granularity at which to assess the implications of climate
risk drivers for these transactions. T he following factors may influence this decision:
Specific physical or transition risk drivers.
Availability of relevant data.
Risk management decisions being supported.
Increasing computational complexity with increasing granularity.
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T his decision drives the selection of available approaches, which then affects a model's output for
risk management.
Top-down and Bottom-up Approaches
T he selection of top-down or bottom-up is among the conceptual considerations that apply to both
exposure mapping and risk estimation.
Top-down approaches typically start by estimating risks at a general or aggregated level and then
allocate (push down) the risk measure to individual parts.
On the other hand, bottom-up starts by dimensioning risk at the component level and then aggregating
these individual risks to provide a general view of risk.
Incorporating Risk Mitigation and Risk Reduction
Banks may need to estimate how potential risk mitigation might moderate or offset climate-related
financial risks when considering how to measure them. Climate risk measurement approaches that
incorporate mitigation strategies are thought of as showing net exposure. On the other hand,
approaches that do not incorporate offsetting strategies are viewed as showing gross exposure.
Banks can disaggregate the impact of risks and mitigating actions by distinguishing between net and
gross exposures.
Climate-related financial risks can also be offset through counterparty measures to adapt to or
mitigate the effects of climate change. T he relationship of exposures to risk drivers within the risk
models of the bank may be modified by these measures. We have two reasons why we should
calculate the gross exposure of an asset or portfolio:
1. By understanding exposure without incorporating risk-offsetting practices, risk decision-
makers will be able to assess the current magnitude of climate-related risks as well as the
future evolution of these risks.
2. Mitigants may lapse, change, fail to materialize, or become obsolete, reducing their
effectiveness in reducing risk.
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Heterogeneities
Heterogeneity is an important consideration when selecting measurement approaches. Climate-
related financial risks vary by bank, depending on geographical location, markets, sectors, political
environments, and technology. T he following are among the common heterogeneities:
Geographi cal heterogenei ty: Climate hazards may vary according to geographical
location.
Sectoral heterogenei ty: Corporate counterparties tend to have similar exposures to
transition and physical risks.
Juri sdi cti onal heterogenei ty: Borders of a particular nation define the limits of legal.
jurisdiction. Exposures within the same jurisdiction may be subject to varying policies.
Sources of Uncertainty
T here is uncertainty associated with estimating climate-related financial risks. As new information is
incorporated into climate models, climate sensitivity estimates typically trend higher, suggesting an
underestimation of climate-related financial risks.
Unique Data Needs Inherent in Climate-related Risks
Unlike traditional data that banks normally use in financial risk analyses, assessing climate-related
financial risks will require new and unique data types.
We have three broad data categories needed to assess climate-related financial risk:
1. Physi cal and transi ti on ri sk dri vers data: T hese are needed to translate climate risk
drivers into economic risk factors (i.e., climate-adjusted economic risk factors).
2. Vul nerabi l i ty of exposures data: T hese link climate-adjusted economic risk factors to
exposures.
3. Fi nanci al exposure data: T hese are required to translate climate-adjusted economic risk
into financial risk.
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1. Physical and Transition Risk Drivers Data
T his data type is the foundation for assessing the effects of climate-related risks on banking
exposure. Climate data and hazard event data belong to this data category. We can use these data as
independent variables in order to alter existing economic relationships and influence economic
outcomes. Government agencies and academic institutions usually provide this data type, while
commercial third parties supply some.
2. Vulnerability of Exposures Data
Besides climate-adjusted economic risk factors, banks and supervisors need information about the
vulnerability of bank exposures to those risk factors. T hese data tend to include features specific to
those exposures, such as geospatial data for corporates, location data for mortgage collateral, or data
on the sensitivity of counterparties to energy prices.
In addition to being used in measurement approaches, these data facilitate the translation of climate-
adjusted economic risk factors into financial exposures. Generally, the relevant characteristics of
these data differ according to the climate risk driver under consideration.
Cl i mate ri sk dri vers determine the relevant characteristics of these data. Counterparties'
geospatial location primarily determines physical risk exposure. On the other hand, the vulnerability
of bank exposures to transition risk depends, however, on the economic activity of counterparties
within particular jurisdictions.
Physi cal ri sk s can result in the destruction of property and inventory, which can affect the
economy. As a result, physical hazards should be sufficiently matched with the location of relevant
physical touchpoints in order to assess the vulnerability of exposure to physical risks.
It may also be necessary to collect information about i nterconnecti ons between retail, corporate,
and municipal borrowers in order to evaluate the impacts of deteriorating local economic conditions
due to a severe or chronic weather event on the local economy. To assess the vulnerability of
corporate counterparties' exposure to transition risk, data concerning their sectors and subsectors,
as well as their carbon sensitivity, are often needed.
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3. Financial Exposure Data
In order to translate the vulnerability of exposures into financial loss estimates, additional data is
usually needed. Banks can turn to variables used in conventional risk measurement approaches. Such
data include data used in estimating cash flows, valuations, or prices. Data on portfolio composition
and counterparties (e.g., probability of default and loss given default) is required to analyze banks'
risk. In addition, data on rollovers, withdrawals, or pricing will be needed to model potential bank
liquidity impacts due to climate risk.
Potential Methodologies
T his section discusses conceptual modeling and risk measurement approaches that can be used to
estimate climate-related financial risks.
Integrated assessment model s (IAMs) combine energy and climate modeling approaches with
economic growth modeling. AIMs link projections of transition risk drivers and greenhouse gas
(GHG) emissions to economic growth impacts. Even though IAMs have been in use for quite some
time, they fail to capture the economic impacts of climate change, extreme weather events, and
adaptation possibilities. Furthermore, estimates of total GDP losses from changes in climate
produced by IAMs may not be realistic since only some physical risks are considered. Climate models
which underpin IAM projections may underestimate the severity of future outcomes if they fail to
capture physical risks which are clearly understood or measured.
Input-output model s estimate how shocks will affect a sector or region's economy based on static
economic linkages among sectors and geographical locations. In the context of climate economics, an
input-output accounting framework is used to examine the impact of policy changes such as an
emissions tax or to estimate the supply chain impacts of extreme climate events.
Computabl e general equi l i bri um (CGE) models allow policy experiments with complex
behavioral interactions between sectors and agents that cannot be solved analytically due to their
complexity. Even though some mechanisms can be explained for CGE outcomes, the level of
complexity makes it impossible to assess the overall significance of each embedded decision rule and
parameter value governing economic agents, resulting in a significant black-box effect.
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Dynami c stochasti c general equi l i bri um (DSGE) models make macroeconomic modeling
even more complicated, especially uncertainty in agent decision-making and endogenous
technological change. T hese models involve complex computations that can be difficult to solve.
Some academic institutions and central banks are taking the necessary steps to make these models
more useful in estimating the impacts of climate-related risks.
Overl appi ng generati on (OLG) models are a more transparent and stylized approach to analyzing
long-term macroeconomic evolutions. By examining the intergenerational distribution of
consumption, these models can highlight one key shortcoming of other approaches: the large role
discount rates play in estimating the social cost of carbon.
Agent-based model s (ABMs) are the most recently introduced model for measuring climate-
related impacts due to their ability to reflect uncertainty and complexity better. An ABM is a
simulation in which economic actors interact with institutions and each other based on a set of
decision-making rules imposed by the modeler.
Other broad ri sk measurement approaches currently being used by banks and supervisors
include risk scores, scenario analysis, stress testing, and sensitivity analysis.
Cl i mate ri sk scores rate the climate risk exposure of assets, companies, portfolios, or even
countries. In order to assign a quality score to exposures, they combine a risk classification scheme
with a set of grading criteria. Banks and supervisors can use climate risk scores to assess the
relative climate exposure of existing and take necessary credit interventions.
Scenari o anal ysi s can help quantify tail risks and clarify climate-related uncertainties by
examining a wide range of plausible scenarios. Climate scenario analysis involves four steps:
1. Identify physical and transition risk scenarios.
2. Relate the effects of scenarios to financial risks.
3. Assess the sensitivities of the counterparty and sector to those risks.
4. Generalize the effects of these sensitivities to find an aggregate measure of potential losses.
Stress testi ng is a subset of scenario analysis aimed at evaluating a bank's near-term resilience to
economic shocks, often through a capital adequacy target.
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Sensi ti vi ty anal ysi s is another subset of scenario analysis that examines the impact of a specific
variable on economic outcomes. T ypically, one parameter is altered across multiple scenarios, and
outputs are observed to see what happens each time the parameter is altered.
Among other new approaches developed, we have natural capital analysis and climate value-at-risk.
Natural capi tal anal ysi s evaluates the negative effects of degradation on a bank. T his process
typically involves four steps:
1. Identifying relevant geographies, sectors, borrowers, and/or assets.
2. Identifying natural capital assets (water, clean air, forests).
3. Identifying potential natural disruptions.
4. Identifying areas, sectors, borrowers, and assets most at risk.
Cl i mate val ue-at-ri sk (VaR): T his approach involves assessments applying the traditional VaR
framework to gauge the impacts of climate change on banks' balance sheets.
Measurement Methodologies of Climate-related Financial

Risks
In this section, we discuss methodologies for mapping and measuring climate-related financial risks as
well as their strengths and weaknesses. We also discuss scenario analysis, stress testing, and
sensitivity analysis, which are used to quantify climate-related financial risks. Measurement
methodologies are discussed separately for banks, supervisors, and third parties, even though we
may have similarities.
Exposure Mapping and Measurement
Bank-level Methodologies
Portfol i o and sectoral exposures: Measures of carbon/emission intensity, energy efficiency or
energy label distribution of a real estate, or physical risk vulnerability of collateral positioned in
risky regions are among the examples here. Banks have launched internal processes to evaluate
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climate-related financial risks qualitatively and map their potential impacts in the absence of
quantitative information. T he indicators or metrics that banks employ to map, measure, and monitor
their exposures can either be distinguished by transition risk or physical risk.
Transition Risks
T he following are observed practices among banks:
T hrough assessing the possible sources of shocks and transmission mechanisms, banks
usually analyze reasons for and the extent to which a particular sector could be impacted
by a transition to a low-carbon economy.
As a proxy for transition risk, banks calculate the carbon footprint of their assets.
Indicators of "greenness" of real estate and financial assets are proxies for transition risk,
as well as measures of alignment with climate targets. Portfolio alignment involves
measuring the gap between existing portfolios and a portfolio that meets a specific climate
target.
Analyzing the potential risk differential between "green" and "brown" activities is a
backward-looking analysis.
Physical Risk
Indicators metrics used to map, measure, and monitor physical risk are intended to identify
concentrations of risk geographically and their type, probability, and severity.
Location-based physical risk scores have been developed for physical risk drivers such as
heat stress, wildfires, floods, and sea level rise. Indicators are identified for each risk
driver that captures changes in physical conditions. A bank can aggregate these indicators
and translate them into facility-level scores, which can then be used to perform due
diligence on clients or to evaluate mortgages annually.
In addition, some banks are using geospatial mapping to assess and monitor how physical
risks may affect their exposures.
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Client or project Ratings and Scores
It is becoming increasingly common for large banks to assess climate-related financial risks
to which individual counterparties may be exposed to both physical risk and transition
risks. Banks have started integrating project-related climate risk assessments into credit
management procedures.
As part of a counterparty-based risk assessment, banks evaluate the climate-related
opportunities and risks of the companies they finance or are considering financing.
Banks often use rating or scoring approaches. Ratings can be internal or external. Climate-
related risks are commonly assessed separately from standard credit risk assessments.
Rating metrics can be based on sector-level characteristics and then adjusted to fit
company-specific characteristics.
To date, banks have integrated climate risk ratings into their overall customer credit rating
only on targeted occasions, although climate risk ratings generally reflect climate-related
factors when granting credit. Climate-related ratings are being developed by several banks
as part of their counterparty credit assessment processes.
Supervisory Methodologies
Supervisors use similar metrics and indicators that banks use to map, measure, and monitor exposure
to climate-related financial risk.
Transition Risks
T he impact of transition risks is often assessed on the basis of regulatory information or ad
hoc surveys.
Bank supervisors typically use indicators for the emissions intensity, carbon footprint, or
sensitivity to climate policies of banks' counterparties at the entity or sectoral level for
corporate portfolios, except for real estate exposures.
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We only have a few analyses for real estate exposure transition risks.
Physical Risks
Even though the analysis of exposures to physical risks varies and its assessments are
often in their initial stage, some supervisors have managed to identify hazards, map and
measure exposures.
Supervisors identify hazards relevant in their jurisdiction and specific regions more
vulnerable to them. Information from third parties is crucial in conducting the above
analysis. Such information includes publicly available information and climate risk scores
provided by commercial vendors.
T he use of these indicators varies in terms of hazard, geographical granularity, and
complexity. Use of flood maps, country vulnerability indicators, and individual industrial
facilities' water stress levels
T he authorities may assess the risk exposure of individual supervised entities or of the
banking system to geographies that are more susceptible to physical risk once salient
physical risk drivers have been identified.
Risk Quantification: Scenario Analysis, Stress Testing, and Sensitivity

Analysis
Bank-level Methodologies
Stress testing or scenario analysis methods can be used to quantify climate-related financial risks at
the bank level.
Most of these exploratory exercises focus on credit risk or market risk analysis. Climate-
related financial risk scenario analyses are currently being conducted to understand
potential impacts on selected portfolios, refine methodologies, and assess limitations and
benefits. Such exercises are used to build capacity and identify counterparties that need to
be involved in the transition process.
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Bank s' transi ti on ri sk anal ysi s focuses on the impact on credit parameters for
specific sectors of counterparties. Specifically, this includes corporate exposure to
climate policies in relevant sectors.
Using a "shadow price" as part of a transition risk sensitivity exercise or scenario is an
example. T his approach involves defining a range of possible future prices on the basis of
external scenarios or internal expertise. We can then use these "shadow prices" to
evaluate the effects on financial variables and hence the counterparty's credit risk profile.
Bank s' physi cal ri sk anal ysi s focuses on corporate and household exposures
(particularly mortgages). Based on this, they infer a potential impact on counterparty
credit quality. Companies in specific sectors (such as electric utilities) can also be affected
by business interruption assumptions.
Observed practices include focusing on sectors more sensitive to weather patterns.
Supervisory Methodologies
Supervisors employ scenario analysis and climate stress tests for micro-prudential
supervision and for informing macro-prudential policies.
At the micro-prudential level, scenario analysis, and stress testing may be used to: (i)
quantify banks' financial exposures vulnerable to specific climate risk drivers and/or (ii)
understand the vulnerability of banks' business models under specific climate scenarios.
At the macro-prudential level, scenario analysis, and stress testing can be employed to
assess whether climate risks are systemic in nature and determine their size and
distribution.
Third-party Approaches
Supervisors and banks sometimes rely on comprehensive methodologies or tools provided by third
parties in addition to specific data or metrics. T he same features apply to third-party methodologies
as in the context of banks and supervisors, such as exposure mapping, scenario selection, shock
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introduction, and impact assessment.
A variety of risk metrics or tools may be provided by the methodologies, including climate
VaR, PD, expected shortfalls, expected losses (EL), income predictions, revenue/cost
analysis, LT V ratios, return on equity, and climate targets.
For physical risks, a risk indicator is often proposed in the form of a climate risk score.
Some methodologies assign a risk rating to an exposure based on the type of hazard to
which it is exposed and vulnerable. Other methodologies leave room for different types of
segmentation or aggregation strategies.
Methodologies developed by third parties incorporate climate sensitivity or vulnerability,
such as water and energy resources, or analyze the types of facilities that are at risk.
Several methodologies consider alternative production sources and insurance policies as
well. Vulnerability is assessed by using damage functions that describe (historical)
relationships between natural disaster magnitude and asset damage.
Strengths and Weaknesses of the Main Types of Measurement

Approaches
T he table below summarizes the strengths and weaknesses of the main types of measurement
approaches.
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Approach Strengths Weaknesses
Integrated
Effectively captures feedback Highly aggregated.
assessment model
between socioeconomic and Typically relies on limited
(IAM) climate systems. damage functions, which
There is internal consistency do not adequately account for
in the projections. extreme weather events.
Policies and assumptions It is not resilient to imperfect
can be accommodated in information and endogenous
models.
events, such as changes in
technology and policy.
Finance, banking, and money
are not modeled in most IAMs.
Computable Analyzes interconnections Assumes decision-makers

general equilibrium across multiple sectors and are perfectly informed.
(CGE) agents of the economy.
Dynamic stochastic Incorporating uncertainty in Computationally intensive.

general equilibrium agent decision-making. Agent decision-making
(DSGE) Used by central banks for assumptions are unrealistic.
policy analysis.
Macro-econometric Utilizes the role of prices Estimates are derived from

to explain market distortions. past observations. Focus on
macro-level analysis; exclude
micro-level analysis.
Overlapping Provides an overview of Closed economy model.

generation intergenerational redistribution. Assumes decision-makers
Incorporates life-cycle are perfectly informed about
investment decisions. future economic conditions
and prices.
Does not take into account
endogenous systemic risks
(climate change or transition).
Input-output Describes environmental Prices have a decisive role in

impacts at the industry level. limiting policy alternatives to
Captures the effects of demand price mechanisms
for goods and services on energy (such as taxes).
and resources.
Captures cascading effects
of events.
Agent-based Micro (agent) level. Computationally intensive.

Agent/economic interactions Significant data is required to
are captured well. develop behavioral rules of agents.
Scenario Effectively analyze tail risks. A chronic hazard is often left out
analysis of scenarios.
Industry collaboration has
Data gaps hinder the analysis.
benefitted scenarios.
Relatively computationally
simple.
Address several aspects of
climate uncertainty.
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Gaps and Challenges in Designing a Modeling Framework to
Capture Climate-Related Financial Risk
In this section, we discuss key challenges in designing a modeling framework.
Limitations of Observed Risk Classification Approaches
Aggregate risk classification approaches not only have advantages but also face several limitations. As
a result of the current availability of data, identification criteria may not be sufficiently granular to
distinguish counterparties. For example, some risk classification approaches assume that
counterparties from the same geographical location have the same risk characteristics. In reality,
however, the transition and adaptation capabilities of counterparties may vary depending on the
specific physical or transition risk driver being assessed.
In addition, the sensitivity of an individual counterparty to climate-related risks may not necessarily
be reflected in a sector or geographical area that is transition-sensitive.
It may be difficult to distinguish between gross and net exposure without being able to clearly
identify and measure the hedging strategies employed by counterparties.
Risk Differentiation and Comparability Across Banks and Jurisdictions
While risk classification systems strive for comparability, it comes at a cost. In order to facilitate
comparisons between banks' exposures within or across jurisdictions, standardization and/or
simplification elements are introduced. So, there is a trade-off between the level of detail and
complexity needed to accurately assess risks and the need to compare and combine risk information
from different banks.
Challenges in the Availability of Appropriate Data
Recently, the availability of data and information has been reported as a major challenge hindering the
development of climate risk measurement processes.
Data Describing Physical and Transition Risk Drivers
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A major challenge here is that information may be out of the scope of traditional financial data
collection. T he available information may lack sufficient granularity and further drawbacks that
hinder the analysis of the data.
Data Describing the Vulnerability of Exposures
Third-party Rating Information
Ratings provided by third parties may not be fully reliable as the users of the ratings may not be so
sure about the accuracy of the data provided by the rated firms. Data users may find it difficult to
identify the methodological approach adopted by data providers since most scores are based on
proprietary models. In addition, the comparability of indicators across vendors is also limited.
T herefore, reconciling these approaches is often difficult.
Counterparty-level Information
Counterparties provide lenders with proprietary non-public information in order to develop a banking
relationship and assess the counterparty's creditworthiness. By acquiring non-public client
information via the lending relationship, the bank is able to address some of the data gaps or quality
issues on a bilateral basis. However, for small counterparties, the availability of proprietary climate-
related client data may be qualitative rather than quantitative. Consequently, data completeness and
precision issues may materialize. Furthermore, banks rarely update data after the underwriting
processes are done. T his could create gaps in climate reporting for existing exposures.
When proprietary non-public information is not readily available, banks may decide to use public
information disclosed by borrowers. It is worth noting that the quantity and quality of public
information depend on the size of the firm. Consequently, it limits the comparability of smaller firms
with large corporations.
Supervisory Reporting Data
Supervisory reports provide recurring and standardized data useful for measuring climate risk. T heir
analysis could provide macro- and micro-level insights into banks' asset portfolios. While existing data
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can be leveraged in combination with third-party providers, current supervisory reporting may not
provide sufficient granularity to assess transition and physical risks.
Challenges in Designing a Modeling Framework to Capture Climate-

related Financial Risks
Scenario Design and Complexity of Climate-related Financial Risks
Financial losses are computed by incorporating all necessary economic and financial variables at a
granularity consistent with a risk classification. However, climate-related financial risks are complex
and coupled with uncertain climate drivers that go beyond intrinsic future uncertainty inherent in
physical and transition risk drivers. Banks and supervisors cite the following aspects as being
particularly challenging in modeling comprehensive scenarios:
Uncertainty around the climate risk drivers involving both transition and physical risk
drivers hinders measurements of climate-related risks.
Capturing the specific impacts of climate scenarios is still a challenge, and hence there is a
need to continue developing modeling frameworks to capture the impacts of climate
scenarios, including stressed variants, within an integrated and tractable modeling
framework.
T here can be issues with the comprehensiveness of modeled impacts. In particular,
capturing the impact of climate scenarios at a level of granularity consistent with a risk
classification is challenging.
Translating Scenario Outputs to Financial Risks
It is particularly challenging to factor in climate scenario-related variables. Models typically use
historical statistics to estimate the impact of given risk drivers on credit risk parameters, such as
PDs or LGDs. To estimate robust relationships, historical observations of risk drivers must have
sufficient depth and variance. T here are no past observations of climate-related risk materializations
that can be used to predict future trends. Moreover, financial models cannot generate empirical risk
parameters.
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Time Horizon-related Challenges
Banks and supervisors have to consider horizons longer than usual due to the long-term nature of
climate change, which makes stress testing exercises and forward-looking assessments challenging.
In addition, uncertainties associated with climate sensitivity modeling are exacerbated by such long-
term horizons, which also impact economic and financial projections, thereby limiting their
reliability when assessing risks. In addition, the uncertainty of a model's projections is directly
proportional to the length of the horizons used in forecasts. Limitations in modeling will further
reduce projection robustness.
Banks have limited ability to internalize negative feedback associated with their short-term lending
decisions. To capture risks over longer time horizons, banks will need to examine the
appropriateness of existing measurement approaches as well as possible modifications.
Operational Complexity in the Measurement of Risk
Measurement of climate risk requires adequate infrastructure, relevant human resources, and/or
sophisticated organizations. In order to assess their overall exposure to climate risks across all their
significant operations, banks need to be able to aggregate and manage large amounts of data. T he
ability to collect, format, and process enormous amounts of climate-specific data is vital to most
methodologies.
In order to measure climate-related financial risk, it may be necessary to pool resources from
various business and functional areas, as well as to develop climate-specific expertise in-house or
hire experts externally. A bank's size and complexity also influence its choice of risk measurement
methodologies. Internal harmonization towards common risk assessment approaches, metrics, and
methodologies may be challenged due to idiosyncrasies among business lines and banking entities.
Smaller, less complex banking groups may face sophistication and resource allocation trade-offs.
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Reading 157: Principles for the Effective Management and Supervision
of Climate-related Financial Risks
Describe the principles for the management of climate-related financial risks related to
corporate governance and internal control framework.
capital and liquidity adequacy and risk management process.
management monitoring and reporting, comprehensive management of credit risk and other
risks, and scenario analysis.
Describe the principles for the supervision of climate-related financial risks related to
prudential regulatory and supervisory requirements for banks and the responsibilities,
powers, and functions of supervisors.
Financial risks associated with climate change can affect banks regardless of their size. T herefore,
banks should think about how climate-related risks affect their operations and evaluate how
financially significant these risks are. T hey must manage the financial risks associated with climate
change in a way that is appropriate for the scope and complexity of their operations and the level of
risk that each bank is willing to take.
Risks associated with the climate can have extensive effects. T he distinct characteristics of these
risks, such as potential transmission channels, the intricacy of the impact on the economy and
financial sector, and uncertainty related to climate change, should be considered by banks.
T he effects of climate change might manifest throughout a wide range of time and are expected to
get worse with time. A bank's typical two- to three-year capital planning horizon may not be long
enough to account for all climate-related risks. Given how unpredictable the timing of these risks is,
banks should approach building their risk management capabilities with caution and flexibility.
Banks should continually expand their knowledge and skills about financial risks associated with
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climate change in line with the risks they confront. Further, banks should make sure they have the
resources set aside to manage these risks.
T here is no recommended board structure in the Basel framework principles.
Corporate Governance
Pri nci pl e 1: Banks should create and implement a robust approach for comprehending and
evaluating the potential effects of climate-related risk drivers. Banks should consider significant
financial risks associated with climate change that could arise across a range of time frames and
incorporate these risks into their overall business plans.
When creating and implementing their business plans, banks should take material physical and
transition risk factors into account. T his includes understanding and assessing how these risks may
affect how resilient a bank's business model is over the short, medium, and long terms. T he board
and senior management ought to be involved in pertinent phases of the procedure. Besides, the
managers and staff at the bank ought to be made aware of the board's strategy.
A bank's strategy and risk management frameworks should consider the serious financial risks
associated with climate change. Besides, the board and senior management should decide whether
changing remuneration practices is necessary.
Banks' risk management plans should be in line with their declared goals and objectives. T he board
and senior management should make sure that their internal strategy and risk appetite declarations
are in line with any disclosed climate-related strategies and commitments.
Pri nci pl e 2: In addition to exercising effective oversight over financial risks associated with
climate change, the board and senior management should clearly define members' and committees'
roles in managing climate-related risks.
Board members or committees should specifically be charged with managing climate-related financial
risks. T his responsibility should be adequately considered as part of a bank's business strategy.
Banks need to make sure that the board and senior management are aware of the financial risks
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associated with climate change and have the knowledge and experience necessary to handle those
risks.
Banks should clearly define and assign duties and responsibilities related to recognizing and managing
climate-related financial risks in their organizational structure and make sure relevant business units
have enough resources to carry out these obligations.
Pri nci pl e 3: Banks should develop the proper policies and procedures and implement them across
the entire organization to achieve successful management of climate-related financial risks.
All relevant activities and business units should implement policies, methods, and controls that
include management of major climate-related financial risks.
Internal Control Framework
Pri nci pl e 4: Banks should include climate-related financial risks in their internal control procedures
to ensure solid, thorough, and efficient identification, measurement, and mitigation of material
climate-related financial risks.
A clear description and assignment of climate-related responsibilities and reporting should be part of
the internal control structure.
Climate-related risk assessments may be carried out throughout client onboarding, credit application,
and credit review stages. In addition, these assessments should run during ongoing client interaction
and monitoring as well as in new products or business approval processes.
Independent of climate-related risk assessments, the risk function should be in charge of conducting
climate-related risk assessments and monitoring. T his involves questioning the initial evaluation made
and ensuring that all applicable laws and regulations are followed.
T he quality of underlying data, the risk governance framework, the business and risk profile, and the
overall internal control structures and systems should all be independently reviewed and objectively
assured by the internal audit function.
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Capital and Liquidity Adequacy
Pri nci pl e 5: Banks should identify and quantify climate-related financial risks and incorporate those
determined to be material over relevant time frames into their internal capital and liquidity adequacy
assessment processes.
Banks should develop procedures to assess how climate-related financial risks that could materialize
within their capital planning horizons will affect their solvency.
It is equally important for banks to determine if climate-related financial risks could result in net
cash outflows or the depletion of liquidity buffers. Banks can do this by considering extreme yet
possible scenarios and including those risks in their internal liquidity management strategies.
T he incorporation of climate-related financial risks that have been deemed material also entails the
incorporation of physical and transition risks that are pertinent to a bank's business model, exposure
profile, and business strategy. T hese ought to be evaluated for inclusion in their stress testing
programs as data over appropriate time horizons.
As the methodology and data used to analyze climate-related financial risks continue to develop over
time and analytical gaps are closed, it is believed that these risks will likely be continuously
incorporated into banks' internal capital and liquidity adequacy evaluations.
Risk Management Process
Pri nci pl e 6: Banks should recognize, track, and manage all financial risks related to the climate that
could significantly deteriorate their financial position and capital resources while making sure their
risk management strategies consider all potential risks and establish a solid plan for dealing with
them.
T he board and senior management should make sure that a bank's risk appetite structure clearly
defines and addresses climate-related financial risks, where applicable.
To begin with, banks should routinely conduct thorough assessments of the financial risks associated
with climate change. T hey should establish such risks' definitions and thresholds for materiality,
including the risks posed by concentrations in particular sectors and geographical areas. Banks need
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to identify important risk indicators that are appropriate for their regular monitoring and escalation
procedures.
Further, banks should think about risk-reduction strategies. Among others, such strategies could
include setting internal caps for the many kinds of significant financial risks related to climate change
to which banks are exposed.
Lastly, banks should keep an eye on future developments. T hey should work to understand and
manage the impacts of climate-related risk drivers on other material risks because there may yet be
undiscovered channels for transmitting these risks to traditional financial risk categories.
Management Monitoring and Reporting
Pri nci pl e 7: For efficient board and senior management decision-making, banks should work to
ensure that their internal reporting systems are capable of monitoring significant financial risks
related to the climate and delivering timely information.
To make it easier to identify and report risk exposures, concentrations, and developing concerns, a
bank's risk data aggregation capabilities should incorporate climate-related financial risks. It should
have mechanisms in place to guarantee the accuracy and reliability of the gathered data. In addition, a
bank should have systems in place to gather and aggregate financial risk data connected to climate
across the entire company.
In order to better understand their transition strategies and risk profiles, banks should think about
actively engaging customers and counterparties and gathering more information. In the absence of
trustworthy or comparable information, banks may consider adopting reasonable substitutes and
assumptions.
Considering the dynamic nature of financial risks associated with climate change, banks should
determine an acceptable frequency for updating internal risk reporting.
To assess, track, and report financial risks associated with climate change, banks should establish
qualitative and quantitative measures and indicators. Any restrictions that impede this should be made
clear to the relevant stakeholders.
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Comprehensive Management of Credit Risk
Pri nci pl e 8: Banks should be aware of how climate-related risk factors affect their credit risk
profiles and make sure that their credit risk management systems and procedures take these risks
into account.
Banks should have carefully thought-out credit policies and procedures to address significant climate-
related credit risks. T hese include appropriate policies and procedures to recognize, quantify, assess,
track, report, and manage or lessen the effects of significant climate-related risk drivers.
Banks should take a variety of risk-mitigation measures into account to control significant climate-
related credit risks. Such measures include altering credit underwriting standards, using targeted
customer interaction, or putting restrictions on loans. Additionally, they need to put restrictions on
the businesses, industries, or geographic regions that they are exposed to that do not fit their risk
tolerance.
Comprehensive Management of Market, Liquidity,

Operational, and Other Risks
Pri nci pl e 9: Banks need to be aware of how climate-related risk factors affect their market risk
positions and make sure that market risk management systems and procedures take important
climate-related financial risks into account.
Banks should determine the risk factors related to climate change that are most likely to have an
impact on the value of the financial instruments in their portfolios. Besides, they should assess the
likelihood that losses will occur and the potential for increased volatility and set up efficient
procedures to limit or mitigate the resulting effects.
An analysis of a sudden shock scenario could be a helpful tool for better understanding and evaluating
the relevance of climate-related financial risks to a bank's trading book. Among other factors, such
evaluation focuses on variation in liquidity across assets exposed to climate-related risk and the
speed at which exposures could reasonably be closed out.
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Banks may consider how the cost and accessibility of hedges could change when assessing their
mark-to-market exposure to climate-related risks.
Pri nci pl e 10: T he influence of climate-related risk drivers on banks' liquidity risk profiles should
be understood, and banks should make sure that their systems and procedures for managing liquidity
risk consider significant financial risks associated with climate change.
Banks should evaluate the effects of financial risks related to climate change on net cash outflows or
the value of the assets that make up their liquidity buffers. Banks should take these effects into
account when calibrating their liquidity buffers and when developing their frameworks for managing
liquidity risk.
Pri nci pl e 11: Banks need to be aware of how climate-related risk factors affect their operational
risk and take the necessary steps to account for these risks if they are significant. T his comprises
risk factors relating to the climate that could increase the risk of strategic, reputational, and
regulatory compliance.
When creating business continuity plans, banks should consider the material climate-related risks
that could have a significant impact on their operations and their capacity to continue delivering
essential services.
Banks should evaluate how climate-related risk drivers affect other risks, such as strategic,
reputational, regulatory compliance, and liability risks. Banks should take such risks into
consideration as part of their risk management and strategy-setting operations.
Scenario Analysis
Pri nci pl e 12: Banks should utilize scenario analysis to evaluate the adaptability of their business
models and strategies to a variety of scenarios and assess their impact on the company's overall risk
profile. A variety of significant time horizons should be considered when evaluating these.
T he goal of climate scenario analysis should be in line with a bank's overall goals for managing
climate risk. T he scenario analysis may include examining how the bank's strategy and the shift to a
low-carbon economy will be affected, as well as measuring the bank's vulnerability to these risks and
65
calculating exposures and potential losses.
Scenario analysis should consider relevant climate-related financial risks. Besides, it should
encompass a variety of conceivable outcomes. Banks should also think about the advantages and
drawbacks of various scenarios and assumptions.
Banks should develop the capacity and knowledge necessary to carry out climate scenario analyses
that are proportional to their size, complexity, and business model. Consequently, larger, more
complicated banks should have stronger analytical capabilities.
Scenario analysis should use a variety of time horizons, from short- to long-term. Risk analysis can be
conducted over shorter time periods with less uncertainty, while longer time frames will have higher
levels of uncertainty.
Climate scenario analysis is a very dynamic field, and the methods employed are expected to change
quickly. Models and findings from climate scenario analysis should be challenged and reviewed
frequently by a variety of internal or external specialists.
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Reading 158: Inflation: A Look Under the Hood
Describe how inflation dynamics differ between a low-inflation regime and a high-inflation
regime.
Explain the process of wage and price formation, the role inflation plays in this process,
and vice versa.
Describe the various channels through which inflation expectations manifest in financial
markets and discuss the inference of inflation expectations from financial markets.
Describe the operation of a central bank’s monetary policy in a low-inflation regime and
evaluate indicators a central bank can use for timely detection of transitions to a high-
inflation regime.
Individual Price Changes and Inflation
Some unknown aspects regarding inflation are revealed by carefully examining the behavior of
sector-specific pricing:
1. When inflation has stabilized at a low level, its development mainly reflects individual
changes in sector-specific prices rather than the co-movement of prices.
2. T he well-documented drop in inflation volatility that is linked to reduced inflation is due to
their co-movement rather than the individual price fluctuations themselves. T he distribution
across prices becomes more subdued in an environment of low inflation. T his is visible in
the following ways:
An index of such spillovers shows a decrease in the intensity and prevalence of
spillovers across sectors.
Outsized price rises are barely noticeable to be passed on to core inflation.
Important item price rises have little impact on total inflation.
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T hese multiple findings are in line with the well-known notion that inflation persistence is lower in
an environment of low inflation, and the inflation rate is susceptible to brief shocks.
In contrast to a high-inflation regime, a low-inflation regime possesses significant self-equilibrating
characteristics. Price adjustments in a single industry hardly ever occur together and have a short-
lived impact on inflation.
Wages and Prices
T he interplay between earnings and prices is the core of the inflation engine. In order for inflation to
persist, prices and wages must both chase each other.
In an environment of low inflation, the response of prices to wages and wages to prices is
more muted.
Wages and prices have a looser correlation when inflation is low. T he time it takes for
salaries and prices to catch up is significant.
Transitions from Low- to High-inflation Regimes
To comprehend the transitions, one must go deeper into the factors that affect wage and price
setting. T he motivations and pricing power of labor and corporations determine how much wages and
prices match each other. T here are three distinct sorts of factors:
I. Structural Forces
T hese include demography, technology, and political views with regard to how market forces should
operate in an economy.
Inflation decreases in tandem with indicators of labor's pricing power, such as measures of
centralization and the intensity of wage negotiations.
II. Cyclical Forces
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T his is how the overall demand compares against an economy's capacity for production, i.e.,
economic slack.
Monetary policy affects economic slack to shift inflation. During transitions, economic
slack assumes a significant function.
III. The Evolution of Inflation
T his has an impact on incentives and, in turn, price power. It is what makes transitions prone to self-
reinforcement.
As it shifts from extremely low levels to higher levels, inflation comes into clear focus. T he inflation
rates that various agents experience converge as the common component of price changes rises.
As inflation rises, it serves as a more pertinent focus point and coordinating tool for economic
agents' decisions. T his encourages them to seek compensation for reductions in their purchasing
power or profit margins. Wage-price spirals may result from this, independent of inflation
expectations.
Since employees' and businesses' inflation expectations are backward-looking, higher inflation leads
to increased anticipated inflation. T his drives agents to seek compensation for future losses. Once
that occurs, the situation will worsen as contracts become shorter and price changes are made more
frequently. As inflation rises, initiatives to improve pricing power are launched. T hese include calls
for more centralization of wage formation, price increases, or labor unrest.
In general, rising inflation can cause a psychological shift toward inflation that feeds off itself.
The Operation of a Central Bank’s Monetary Policy in a Low-

inflation Regime
Monetary Policy
Monetary policy has always influenced the process of inflation in two ways:
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I. Using the Framework's Characteristics
Objectives, methods, techniques, institutional foundations, and the degree of the central bank's
independence from the government are all relevant characteristics in this context. T hese
characteristics have the largest impact on wage, price formation, and inflation expectations.
II. Through Changes to the Framework's Policy Position
T he framework's policy position can be changed through such actions as modifying interest rates,
balance sheets, and signaling. T he position has the most impact on overall demand.
Monetary policy may afford to be more flexible and tolerant to sustained departures of inflation from
clearly defined targets in an established low-inflation regime. In such an environment, inflation
displays significant self-equilibrating characteristics. Monetary policy appears to lose momentum,
and the central bank is prompted to change its policy-adjusting tools more forcefully. As a result, any
unfavorable consequences, such as those brought on by interest rates, may be amplified.
T he decline in momentum reflects how prices move in an environment of low inflation. It makes
sense that monetary policy would affect common price fluctuations more than unique price changes.
T his is because the common component of price movements is more closely related to aggregate
demand. In a low-inflation environment, however, the common component decreases significantly.
A prompt and forceful response to protect price stability is essential given the self-reinforcing
nature of transitions from low- to high-inflation regimes. Due to the behavioral changes, their causes,
and the potential damage to the central bank's reputation, leaving a high-inflation regime uncorrected
can be extremely expensive. Particularly risky economies are those with a long history of inflation
or weak macroeconomic fundamentals. Due to the significant currency depreciations financial
markets suffer under such circumstances, changes can be very quick.
T he inherent uncertainty of transitions is a problem for central banks. T here isn't an entirely
trustworthy real-time indicator. And it's during transitions that typical models struggle the most.
Models are least useful when they are most needed because of the self-reinforcing dynamics and the
data on which they must be evaluated. T he most accurate indicator is the presence of second-round
effects of wage-price spirals. However, the costs of taking corrective action may have significantly
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increased by the time these effects manifest.
New insights are gained by looking at the inflation engine from the inside. It encourages us to
consider the inflation process as two quite distinct regimes with self-reinforcing transitions from
low to high inflation regimes. In addition, it offers guidance on how to adjust monetary policy in
response to the characteristics of these regimes and the crucial transitions between them,
highlighting the importance of a prompt and effective reaction.
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Question
In the past five years, the fictitious country of Macrovia has shifted from a low-inflation
regime to a high-inflation regime. Historically, Macrovia has managed to maintain low
inflation rates by instituting stringent monetary and fiscal policies. However, recently,
due to various geopolitical circumstances, Macrovia is experiencing an inflationary
period that is much higher than usual. It has been observed that the spillover of price
changes across sectors is more apparent than before. Along with this, significant relative
price changes and currency depreciation have been fueling inflation further.
In the context of the changes in inflation dynamics in Macrovia, which of the following
statements best describes the primary difference between the country's past low-
inflation regime and its current high-inflation regime?
A. T he persistence of aggregate inflation is higher in the high-inflation regime due to
enduring individual price changes.
B. T he high-inflation regime is more self-stabilizing compared to the low-inflation regime.
C. In the low-inflation regime, price co-movements explain changes in the price index
more than concurrent relative price changes.
D. Large price changes in core inflation and volatile components like food and
commodities have less influence on inflation in the high-inflation regime.
Solution
T he correct answer is A.
In high-inflation regimes, price changes across sectors are more likely to spill over, and
the persistence of aggregate inflation tends to increase, in part due to enduring individual
price changes. T his is the case because high-inflation regimes are not self-equilibrating
and are increasingly affected by large relative price changes and currency depreciation,
which fuel inflation further.
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Choi ce B i s i ncorrect because it's the low-inflation regimes that are more self-
stabilizing, not high-inflation regimes. Important relative price changes do not last long in
low-inflation regimes and do not impact aggregate inflation significantly.
Choi ce C i s i ncorrect because in a low-inflation regime, changes in the price index are
explained more by concurrent relative prices changes, instead of price co-movements.
Choi ce D i s i ncorrect because, in a high-inflation regime, large price changes in core
inflation and volatile components, like food and commodities, along with currency
depreciations, have a greater influence on inflation. In contrast, in a low-inflation regime,
the influence of these large price changes on inflation tends to decline.
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Reading 159: The Blockchain Revolution: Decoding Digital Currencies
Explain how a blockchain-based cryptocurrency system works and compare
cryptocurrencies to conventional money and payment systems.
Describe elements of a decentralized finance structure, including smart contracts,
tokenized assets, decentralized autonomous organizations, and decentralized exchanges.
Define stablecoins and assess their advantages and disadvantages, including their potential
contribution to systemic risk and regulatory considerations.
Explain the advantages, disadvantages, and potential applications of a central bank digital
currency.
How a Blockchain-based Cryptocurrency System Works
Money, Digital Money, and Payments
Money is a form of social credit because it allows people to exchange goods and services within a
community. In smaller communities, people's actions can easily be tracked and recorded, allowing for
a communal ledger of individual consumption and production decisions. In larger communities, where
people mostly don't know one another, this system doesn't work, so money is used as a medium of
exchange. Money can be in physical form, like cash, or digital form, like electronic bank transfers.
Physical cash transactions are direct between parties, while digital payments require a trusted
intermediary to process the transfer.
Cryptocurrencies, Blockchain, and the Double-spend Problem of

Digital Money
Cryptocurrencies are digital information transfer mechanisms that can be used as a form of money
and payment system. Unlike conventional money systems, cryptocurrencies are not controlled by a
single entity, but by a group of volunteers called miners. Miners are responsible for keeping track of
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all cryptocurrency transactions. Miners keep their records in a digital ledger known as the
blockchain. T he protocols that govern the blockchain are embedded in computer code, and
cryptocurrency users must trust that the rules for using them are fair and won't be changed without
a good reason. However, managing this digital ledger is not easy. T here is a risk that someone could
duplicate the digital money and spend it multiple times, causing what is known as the "double-spend
problem" in the monetary system.
Creating multiple copies of a digital file is easy, allowing the same digital file to be spent twice. T his
makes the double-spend problem a challenge in digital money systems. Each society member would
have their own personal money printing press, which is unlikely to work successfully if they could
generate personal copies of digital money files. Despite not being immune to the double-spend
problem, physical currency can be designed to make counterfeiting sufficiently expensive. T he
traditional approach to solving the double-spend problem with digital money is to provide a reliable
third party, such as a bank, to aid in mediating the movement of value between accounts in a
ledger. Bitcoin was the first money and payment system to solve the double-spend problem for digital
money without the help of a trusted third party, and below is an explanation of how they managed to
do that:
The Digital Village: Communal Record-keeping
Cryptocurrencies transaction record keeping can be likened to small communities whose members
know one another. Each member in these communities has a history of behavior known to others.
T his history is a virtual database that is shared among members. T he maintenance of this database is
a shared responsibility, not solely the responsibility of one person. T he community records
members' contributions here. Each member's record is a reputation history based on what
individuals have contributed to the community. In this sense, the credit they receive from the
community can be considered a form of money. Even though it is possible for individuals to fabricate
their history for personal gain, open and shared ledgers are difficult to alter without communal
consensus. T his is the fundamental concept behind decentralized finance (DeFi).
Governance via Computer Code
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All social interaction is subject to rules that govern behavior. Behavior in small communities is
governed largely by unwritten rules or social norms. In larger communities, rules often take the
form of explicit laws and regulations. In financial markets, the rules governing behavior and
transactions are important for maintaining the stability and integrity of the system. In the case of the
United States, the Federal Reserve plays a central role in this system. T he Federal Reserve Act of
1913, as well as other laws and regulations, govern all the actions the Federal Reserve takes. T hese
rules can change over time as political support for certain changes emerges. Similarly, in the case of
cryptocurrencies, the rules and protocols that govern the monetary policy and payment processing
are built into the code and are difficult to change. Some individuals see this as an advantage since it
provides a clear and unchanging framework for the system.
How Blockchain Technology Works
While data itself is the centerpiece of operations for any database management system,
cryptocurrencies use a database known as the blockchain. A blockchain is like a ledger of money
accounts with unique addresses. T hese money accounts work like post boxes such that anyone
visiting the post offices is permitted to see the money balance in each account, but you need the
correct password to access the money. T hese passwords are generated automatically upon account
opening and are only known to the account user. T he names of these accounts are pseudonymous.
Cryptocurrencies are considered "digital bearer instruments" because possession of the private
password determines their ownership and control. Note that cryptocurrencies are often referred to
as "digital cash" thanks to their similarity to physical cash.
Cryptocurrency transactions are similar to using physical cash since neither permission nor
personal information is required. By downloading a cryptocurrency wallet, anyone with internet
access can communicate with the system's miners and generate a public address and private key for
their account. T his will create a similar front-end experience to online banking for managing money
balances and initiating payment requests. However, if the private key is lost or stolen, there is no
way to recover the funds.
While cryptocurrencies have gained popularity because of their provocative and glamorous
appearance, the real innovation lies in the way in which their databases operate. Each money
account is managed in accordance with a set of computer code rules that regulate access to the
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database. Additionally, protocols govern how account managers are rewarded for updating the
database. Proof-of-Work (PoW) and Proof-of-State (PoS) are two common protocols used in this
process. It is worth noting that some form of gatekeeping is required to prevent the addition of
unwanted data to the database. T he primary economic question is whether these protocols can
process payments and manage money accounts more efficiently, cheaply, and securely than existing
centralized finance systems.
Native Token
To record money balances, cryptocurrency uses a monetary unit known as native tokens. T hese
tokens are similar to foreign currencies. However, computer algorithms, not a country's
policymakers, determine their value. T he potential for capital gains from appreciating the value of
the native token relative to the U.S. dollar often drives the excitement around cryptocurrencies.
However, the fundamentals of a cryptocurrency that would generate continued capital gains for
investors beyond the initial adoption phase are unknown. Furthermore, while the supply of a specific
cryptocurrency, such as Bitcoin, may be limited, the supply of close substitutes may be unlimited.
T he total market capitalization of cryptocurrencies will likely continue to grow. Still, this growth
may be attributed more to the creation of new cryptocurrencies than to a rise in the price per unit
of any given cryptocurrency, such as Bitcoin.
Cryptocurrency Application
Cryptocurrencies, like Bitcoin, have primarily been used as a store of value rather than a medium of
exchange due to their volatility. However, their potential use as a vehicle currency for international
remittances and their decentralized nature, which operates independently of any government or
concentration of power, makes them attractive to some individuals and organizations. Furthermore,
anyone can access Bitcoin payments freely and without permission, provided they have an internet
connection. However, it also makes it easier for illegal activities and money laundering to occur. El
Salvador's recent adoption of Bitcoin as a legal tender has aroused interest as a case study of how a
cryptocurrency can perform as a domestic payment system.
Using blockchain technology, Bitcoin operates as a decentralized autonomous organization (DAO)
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utilizing open-source computer code on a large network of computers. Moreover, it has no physical
location, is not required to be registered as a business, and lacks a CEO and traditional employees.
Since it has a fixed supply of 21 million BT C and allows anyone to participate, it's an ideal platform
for fast, low-cost, high-value transactions.
Policy Considerations of Cryptocurrency
Central banks view cryptocurrencies the same way they do (view) foreign currencies, which
governments may consider a threat. Controlling cryptocurrencies would be difficult due to their
nature of being easily accessible and not requiring permission. Cryptocurrencies may also constrain
domestic monetary and fiscal policies by limiting the amount of seigniorage available to fund
government expenses. Furthermore, while issuing debt denominated in foreign currency, such as the
U.S. dollar, may be less expensive, it may cause problems if the domestic currency depreciates,
making it difficult for debtors to repay and potentially causing a financial crisis. If debt instruments
are denominated in cryptocurrency, there is no way to negotiate with the cryptocurrency's
decentralized organization (DAO). As a result, domestic regulators may be more strict in regulating
the issuance of cryptocurrency-denominated debt if it poses a significant risk to the system.
Elements of a Decentralized Finance Structure
Decentralized finance, or DeFi, refers to financial activities conducted on blockchains. Unlike
traditional finance, which relies on intermediaries and centralized institutions, DeFi uses smart
contracts to enable transactions between parties without the need for intermediaries, which can
significantly reduce costs and give parties more control over the terms of agreements. However,
intermediaries continue to play an important role in areas such as verification and enforcement, and
they may not disappear entirely. T his section describes the concepts of DeFi and its implications.
Smart Contracts
A smart contract is a computer program that performs a set of predefined actions agreed upon by the
parties. Nick Szabo first introduced it in the 1990s as a crude example of a vending machine. Smart
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contracts enable secure financial transactions without the use of third parties and can be used for
purposes other than traditional financial transactions. Ethereum is a blockchain platform that
supports smart contracts, which in this case, are a type of account with their own balance that can
interact with the network. Like cryptocurrencies, smart contracts allow for secure and transparent
transactions between untrusted parties without intermediaries. Consider a collateralized loan as an
example. In traditional finance, such a transaction would involve many parties, including the lender,
the borrower, a broker, financial intermediaries, appraisers, loan servicers, asset custodians, and
others.
On the other hand, a smart contract is a computer program that details an agreement and stores it on
the blockchain. It contains information about the loan and the actions that will be taken based on
compliance. T he blockchain ensures the contract's successful execution, removing the need for any
additional parties other than the borrower and lender.
Asset Tokenization
Asset tokenization involves the conversion of physical assets into digital tokens that can be used on a
blockchain. T his allows assets such as real estate to be used as collateral in smart contracts.
However, enforcing blockchain property rights for assets that exist in physical form remains a
challenge for DeFi. Tokens also have non-financial uses, such as granting voting rights to
organizations and creating unique digital artistic images through nonfungible tokens (NFTs), which
serve as a certificate of authenticity. T he key advantage of NFTs is that they use the security of the
blockchain to ensure authenticity and security, rather than relying on signatures that can be forged.
Decentralized Autonomous Organizations
Smart contracts have the potential to fundamentally alter the way institutions are organized and
managed. T his applies to investment funds, corporations, as well as public goods and services. One
such application is the decentralized autonomous organization (DAO), which is an organization
represented by computer code and governed by smart contracts on a blockchain. A popular example
is MakerDAO, which issues the stablecoin Dai and is governed by its stakeholders, who use tokens to
make decisions about protocol changes. Governance refers to the rules that balance the interests of
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different stakeholders in an institution. In traditional corporations, the board of directors plays a
critical role in corporate governance, addressing issues such as agency problems where managers do
not act in the best interest of shareholders. DAOs offer an alternative governance model by encoding
rules in a smart contract, replacing the traditional top-down structure with a decentralized
consensus-based model. Examples include Uniswap, a decentralized exchange, and Aave, a borrowing
and lending platform. T hese started out with development teams in charge of operations and
decisions. Eventually, they distributed governance to the wider community through the issuance of
tokens, allowing holders to submit proposals and vote on them.
Centralized and Decentralized Exchanges
Nowadays, crypto-assets are mostly traded through a centralized exchange (CEX), whose operation
is similar to a traditional bank or a broker. A client opens an account by providing personal
information and then depositing funds. T he client can then trade crypto assets at prices listed in the
exchange. T he client's assets are in the custody of the exchange; hence the client does not own
these assets. As such, all client transactions are recorded on the database of the exchange rather
than on a blockchain.
On the other hand, decentralized exchanges (DEX) use smart contracts for peer-to-peer trading
without intermediaries, allowing traders to keep custody of their funds and interact directly with
smart contracts on a blockchain. Order books, which list buy and sell orders for a given asset as well
as their offer and bid prices, can be used to implement DEX. CEXs operate like DEXs. However,
with DEXs, smart contracts handle the list and transactions. When all transactions are handled on a
blockchain, the order book is referred to as "on-chain." Otherwise, it is referred to as "off-chain."
One particular issue of concern with order books is their potential to slow execution and lack of
liquidity. DEX aggregators and automated market makers (AMM) can solve the liquidity problem,
making trades faster and cheaper. AMMs are currently the most popular form of DEXs since they
offer the best solution to liquidity problems.
Stablecoins
As discussed previously, cryptocurrencies are highly unsuitable as payment instruments due to their
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extreme exchange rate volatility. A stablecoin is a cryptocurrency whose value is linked to an
external asset, such as the U.S. dollar, to make it more useful as a payment method. To accomplish
this, the stablecoin must persuade its owners that it can be exchanged for U.S. dollars at par or at a
fixed exchange rate. T he aim of this design is to increase the use of stablecoin by making it more
appealing as a payment option. One significant advantage of using stablecoin instead of a traditional
bank account is that it allows for lower-cost USD payments due to its use of blockchain technology
for more efficient account management and payment processing services, which can be passed on to
customers in the form of lower fees. It can also be viewed as a method of avoiding certain costs by
transferring the transaction outside the regulated environment.
Financial Stability Concerns
Stablecoins based on the U.S. dollar are similar to money market funds in that the price of their
liabilities is tied to the U.S. dollar. T hey are also closely related to banks that do not provide deposit
insurance. As pointed out in the 2007-09 financial crisis, even money market funds are vulnerable to
runs if their assets are of poor quality. Similarly, unless fully backed by U.S. dollar reserves or bills,
U.S. dollar-based stablecoins may experience a bank run. T his can happen if a stablecoin is unable to
sell its assets at reasonable prices or raise the funds required to meet its redemption promises. T his
poses a risk not only to stablecoin holders but also to the financial system as a whole.
Regulators are also concerned about the possibility of systemic risk if a stablecoin run leads to a fire
sale of commercial paper, as well as negative economic consequences for firms that rely on this
market. Regulators face challenges when dealing with stablecoins that are "too big to fail" and can
rely on central bank support. Nonetheless, the use of smart contracts to design more resilient
financial structures may make stablecoins "run-proof."
Regulatory Concerns
As the world of stablecoins evolves, regulators face concerns similar to those faced by the
traditional banking industry. Banks create money by issuing deposit liabilities with a fixed exchange
rate against U.S. dollars, as well as credits held in Federal Reserve accounts. T hey use low-earning
liabilities to purchase high-earning assets. Commercial banks are referred to as fractional reserve
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banks because they typically hold only a small percentage of their assets as reserves. T he
implementation of federal deposit insurance has largely eliminated retail bank runs. T he Federal
Reserve also provides emergency lending to banks, but regulatory restrictions accompany these
benefits on bank balance sheets and business operations.
Some stablecoin issuers attempt to replicate the business models of banks or top institutional money
market funds, which can be a profitable venture. However, this approach carries significant risks
that could lead to instability. Other stablecoin issuers, on the other hand, focus on providing payment
services by holding only risk-free assets such as U.S. T reasury securities. T hese stablecoins are
similar to government money market funds. Stablecoins may adhere to government regulations, hold
only risk-free assets, and generate profits via transaction fees or net interest margins. T he goal is to
keep stablecoin users' capital requirements low.
Advantages, Disadvantages, and Potential Applications of a

Central Bank Digital Currency
According to T he Board of Governors of the Federal Reserve System (BOG), in its recent
publication "Money and Payments: T he U.S. Dollar in the Age of Digital T ransformation," a central
bank digital currency (CBDC) is a "digital liability of the Federal Reserve that is widely available to
the general public." In other words, this is saying that anyone can open a bank account at the central
bank.
Currently, only depository financial institutions and a limited number of agencies, including the
federal government, are allowed to have accounts at the Federal Reserve, known as reserve
accounts. T hese accounts hold bank reserves, and the account held by the federal government is
referred to as the T reasury General Account. Although a form of CBDC already exists at a wholesale
level for a select group of agencies, the question of whether to expand access to it and how to do so
remains. T he public already has access to digital currency in the form of digital deposit liabilities
issued by banks and physical currency, i.e., cash, which is considered a central bank liability.
However, bank deposits are not legally considered central bank or government liabilities, whereas
CBDC would be considered legal tender.
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Federal Deposit Insurance
Bank accounts in the United States are today insured by the Federal Deposit Insurance Corporation
up to $250,000. It can be argued that retail bank deposits are a de facto government liability.
Furthermore, given the Federal Reserve's role as lender of last resort, large-value bank deposits can
be argued to be a de facto government liability. T his means that the legal status of a CBDC in
comparison to bank money may not be as important in terms of money account security.
Counterparty Risk Concerns
When it comes to money and payments, security isn't the only thing to think about. T here is also the
issue of counterparty risk, which can impact access to funds. Even if your money is insured in a
bank account, accessing it may be delayed if the bank is experiencing financial difficulties. T his is
one of the reasons corporate cash managers frequently use the repo market, where deposits are
secured by T reasury securities that can easily be sold if the deposited cash is not returned on time.
A CBDC with no account size limits would provide fully insured money accounts for corporations
with no counterparty risk. If properly implemented, this could potentially help streamline certain
aspects of the money market.
Potential for Efficiency Gains
It's a difficult issue to address when it comes to improving the overall efficiency of CBDC's payment
system. In light of the current state of the U.S. payment system, which lags behind developments in
other countries, some argue that a properly designed CBDC could be a game changer. However, it is
important to note that the United States' payment system is rapidly evolving, with platforms for real-
time payment services, such as the Federal Reserve's FedNow and the Clearing House, emerging.
It's also important to note that there is no "ideal" way to organize a payment system. A payment
system's primary function is to process payment requests and transfer funds between accounts.
While the concept is simple, actual implementation and operation can be quite difficult.
In order to prevent fraud and ensure efficient messaging systems, any system would require strong
security measures. T he potential of CBDC has divided opinion, with some strongly in favor and
others less so. T heoretically, a private, public, or private-public partnership could all be viable
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options. T he Federal Reserve is primarily concerned with wholesale payments, whereas the private
sector typically serves the retail sector. A CBDC could be designed to respect this division of labor
by allowing free entry into the business of "narrow banking" or by providing direct access to CBDC
and delegating retail-level processing to private firms.
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Question
Consider the fictional cryptocurrency, Plutocoin, a prominent

blockchain-based system that uses a unique blend of proof-of-work
(PoW) and proof-of-stake (PoS) protocols. Joe, a software engineer, is
debating whether to use Plutocoin as his primary means of
transaction instead of conventional money and payment systems.
Which of the following would be the most accurate statement for Joe
to make?
A. Plutocoin, being a cryptocurrency, does not provide the same security as conventional
banking systems.
B. Plutocoin transactions require the disclosure of personal information, similar to
conventional banking systems.
C. Plutocoin transactions are based on digital bearer instruments, making it akin to digital
cash.
D. Plutocoin transactions are only accessible to a certain group of people, unlike
conventional banking systems.
Solution
Cryptocurrencies like Plutocoin are indeed akin to digital cash. T hey are digital bearer
instruments, where ownership control is defined by possession of a private key. Just as
physical cash doesn't need permission to acquire and spend, cryptocurrencies can be
similarly managed. T his is unique to cryptocurrencies compared to conventional banking
systems.
A i s i ncorrect because Plutocoin, as a cryptocurrency, actually offers a high degree of
security, often more than conventional banking systems. T his is due to the blockchain
technology and private key mechanisms that secure each account.
B i s i ncorrect because one of the main features of cryptocurrencies like Plutocoin is
the ability to transact without having to disclose any personal information, unlike
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conventional banking systems where personal information is usually required.
D i s i ncorrect because, contrary to the statement, cryptocurrencies like Plutocoin
can be accessed by anyone with internet access and does not require any permissions or
qualifications to acquire or spend, unlike some conventional banking systems that may
have restrictions on who can open an account.
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Reading 160: The Future Monetary System
Identify and describe the benefits and limitations of crypto and decentralized finance (DeFi)
innovations.
Describe the role of stablecoins in DeFi ecosystems and differentiate among the types of
stablecoins.
Discuss possible advantages and disadvantages of a monetary system based on CBDCs.
Understand the risks posed by the centralization that occurs in DeFi ecosystems and
crypto exchanges (CEX).
Outline the regulatory actions recommended by the BIS to manage risks in the crypto
monetary system.
T he monetary system is used by people all over the world to conduct payments and other financial
transactions. T he organizations and structures that surround and support monetary exchange make
up the monetary system.
T he central bank, which maintains the system's fundamental functions and issues money, is at the
center of the monetary system. T rust in the central bank ultimately underpins confidence in the
monetary system.
T he majority of payments are carried out by commercial banks and other private payment service
providers (PSPs), who also provide services to customers. T his separation of roles encourages
competition.
Although the central bank-centered monetary system has done a good job historically, new demands
are being placed on it by technical advancements brought on by digital innovations such as those in
the crypto universe.
Decentralization is a foundational principle in the crypto universe. To make the system self-
sustaining and free from the influence of strong entities or groups, crypto envisions checks and
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balances provided by several anonymous validators. Decentralized finance, also known as "DeFi,"
aims to replicate traditional financial services in the crypto universe.
Recent occurrences have shown that the crypto ideal and its actuality are different.
T he collapse of the TerraUSD stablecoin and its companion coin Luna has highlighted the
system's fragility.
T he crypto world, in particular, lacks a nominal anchor. It has become apparent that crypto
has deeper structural limits that prevent them from achieving the effectiveness, stability,
or integrity levels necessary for a suitable monetary system.
It is prone to fragmentation, and scaling its applications without sacrificing security is
impossible, as shown by the high fees.
T he system's use of unregulated intermediaries is of grave concern.
Retail, fast payment systems (FPS) and central bank digital currencies (CBDCs), and decentralization
and permissioned distributed ledger technology (DLT ) are well positioned to serve the public interest
by lowering costs and increasing convenience while upholding the integrity of the system. Faster,
safer, and less expensive payments and settlements are supported by these developments
domestically and internationally.
What do we Want from a Monetary System?
T he monetary system, which comprises money and payment systems, is a collection of institutions
and structures that facilitate monetary exchange.
Safety and stabi l i ty - Money must do the following three functions in order to
guarantee the security and stability of the system: a store of value, a unit of account, and a
medium of exchange.
Accountabl e - Key entities that are dependent on the financial system must be held
accountable, either through particular mandates for public authorities or through
88
appropriate regulation and oversight for private businesses.
Effi ci ent - To facilitate economic transactions on a large scale and at a cheap cost, the
monetary system should be effective and enable dependable, quick payments.
Fi nanci al i ncl usi on - To spread the advantages of economic activity and encourage
financial inclusion, everyone should have access to affordable, basic payment services,
particularly transaction accounts.
User control - T he system must guarantee user control over financial data and defend
privacy as a fundamental right.
Integri ty - By preventing illegal activities such as fraud, financing of terrorism, and
money laundering, the integrity of the system must be preserved.
Adaptabl e - T he monetary system must be aware of technological advancements,
anticipate user needs and future advances, and adapt to shifting demands from consumers
and enterprises. Additionally, it ought to promote innovation and competitiveness.
Open - T he monetary system also needs to be open, interoperable, and adaptable both
domestically and internationally in order to better serve a world that is becoming more
connected.
Challenges faced by today’s monetary system include:
Users' changing needs and concurrent technological changes have highlighted areas for
improvement.
Current payment methods can occasionally be complicated and expensive to use, which is
partly due to a lack of competition.
A sizable portion of individuals still lacks access to digital payment methods, particularly in
developing and emerging market economies.
Demands for improvements to institutional structures and technological advancements to
meet the system's changing societal demands.
89
The Promise and Pitfalls of Crypto
Stablecoins, which aim to tie their value to fiat currencies, highlight the crypto industry's desire to
capitalize on the legitimacy offered by the unit of account issued by the central bank. Stablecoins'
dependence on the legitimacy of central bank money is a major structural weakness that is readily
apparent. Additionally, stablecoins are frequently not as stable as claimed by their issuers.
T he abundance of coins also highlights another crucial weakness in the structure of
cryptocurrencies, namely their fragmentation into numerous incompatible settlement levels.
T he fragmentation of the cryptocurrency market reveals its challenge. T he more users that flock to
a single blockchain system, the worse the congestion and the higher the transaction fees, which
invites newer competitors who might forgo security in favor of greater capacity.
Crypto gives a sneak preview of potential functionality. T hese result from the ability to bundle
transactions and carry out the automatic settlement of bundled transactions in a conditional manner,
enabling higher functionality and speed.
The Building Blocks of Crypto
Bitcoin presented a revolutionary concept that gave rise to cryptocurrency: a decentralized method
of transferring value on a permissionless blockchain. T he validation of transactions on a public ledger
can be done by any participant acting as a validating node. Record-keeping on the blockchain is
carried out by a variety of anonymous, self-interested validators as opposed to depending on trusted
intermediaries (such as banks). T ransactions with cryptocurrencies are validated by decentralized
validators and recorded on the public ledger.
How does Crypto Work?
A buyer broadcasts the specifics of the transaction when a seller wishes to send cryptocurrency to
them. Validators compete for the opportunity to verify the transaction, and whoever is chosen to do
so adds the transaction to the blockchain. T he exact names of the parties involved in transactions are
therefore kept a secret, but the history of every transaction is publicly viewable and linked to
particular wallets.
90
In order to make the system self-sustaining, miners and validators receive financial rewards for
carrying out their duties in accordance with the rules. Cryptocurrency rewards can be received in
the form of transaction fees or from rentals earned by "staking" one's coins in a blockchain that uses
proof-of-stake. T he more frequently a node acts as a validator, and the higher the rents are, the
higher the stake.
Many blockchains and cryptocurrency coins have emerged since the creation of Bitcoin, most
notably Ethereum, which enables the use of "smart contracts" and "programmability." T he use of
self-executing code known as "smart contracts" can automate market processes and do away with
the middlemen who were previously needed to make choices. Smart contracts are transparent and
less susceptible to manipulation because the underlying code is open to the public and can be
examined. T he ability of smart contracts to integrate many parts of a system is a key aspect. By
merging several instructions into a single, smart contract, users can conduct complicated
transactions on the same blockchain. By "tokenizing," they can turn assets into digital
representations.
Since smart contracts cannot directly access data that is "off-chain" or outside the specific
blockchain, they depend on intermediaries to supply this information (so-called oracles). But these
modifications also bring new issues. More centralized validation techniques are frequently used to
boost capacity, which weakens security and concentrates insiders' benefits.
Stablecoins in Search of a Nominal Anchor
With the stated goal of reshaping the financial system by eliminating middlemen and lowering costs,
decentralized finance provides financial services and products. Lending, trading, and insurance are
the three major forms of financial activity, though the DeFi ecosystem is expanding quickly.
Lendi ng. Users can make interest-bearing loans of their stablecoins to borrowers who pledge other
cryptocurrencies as security on lending sites.
Tradi ng. Decentralized exchanges (DEXs) are venues for direct trades between holders of
cryptocurrencies or stablecoins.
91
Insurance. Users of DeFi insurance platforms can protect themselves against things like improper
handling of secret keys, exchange hacks, and unsuccessful smart contracts.
Due to their pegs to fiat money or other assets like gold, stablecoins are essential to the DeFi
ecosystem. T hey value the credibility that the asset or unit of account issued by the central bank
offers. T heir primary use case is to combat the extreme price volatility and limited liquidity of
unbacked cryptocurrencies like Bitcoin. T heir use also prevents costly, frequent conversions
between cryptocurrencies and bank deposits in fiat currencies.
T he two main types of stablecoin are asset-backed and algorithmic.
Asset-back ed stabl ecoi ns like Binance USD and USD Coin are typically administered by a central
intermediary who invests the underlying collateral and organizes the generation and redemption of
the coins.
Al gori thm stabl ecoi ns. To sustain their value in relation to the target currency or asset,
algorithmic stablecoins rely on sophisticated algorithms that automatically rebalance supply.
T he reliability of stablecoin stabilization methods heavily rests on the quality and transparency of
their reserve assets, both of which are frequently terribly deficient.
Stablecoins lack the characteristics required to support the upcoming monetary system.
T hey cannot make use of the legal constraints and protections of bank deposits or the
central bank's role as a lender of last resort.
T hey must import their credibility from sovereign fiat currencies.
T hey restrict liquidity and risk fracturing the monetary system.
Structural Limitations of Crypto
T he inherent limits of permissionless blockchains, which eventually result in system fragmentation,
congestion, and excessive costs, are a problem for cryptocurrencies. T ransactions are recorded on
the blockchain by self-interested validators.
92
In order to maintain the decentralized consensus system, validators must be motivated by financial
rewards that are sufficiently high. Sincere validation must generate more rewards than possible gains
from cheating. If compensation becomes insufficient, validators may be tempted to cheat and
compromise the security of the cryptocurrency.
T he blockchain's capacity must be restricted in order to maintain incentives for validators and keep
fees high enough. In times of congestion, users may offer larger fees to have their transactions
processed more quickly because validators have the discretion to determine which transactions are
approved and processed.
T he so-called scalability trilemma is manifested in the restricted scale of blockchains. Only two of
the three properties—scalability, security, or decentralization—can be attained by permissionless
blockchains by virtue of their design. Decentralization and incentives improve security, but
maintaining incentives through fees causes congestion, which restricts scalability. As more recent
blockchains that compromise on security have entered the crypto universe, the restricted
scalability of blockchains has caused the crypto world to become fractured.
T here are increased dangers of theft and hacking in a system of rival blockchains that are not
interoperable but are supported by speculation. Interoperability refers to the ability of users to
access, share, and validate transactions across several blockchains. Since each blockchain
represents a distinct record of settlements, interoperability is not possible in practice. To enable the
movement of coins between blockchains, a few "cross-chain bridges" have emerged. T hese
bridges depend on a small number of validators who, in the absence of regulation, must be believed to
refrain from engaging in unethical activity. However, a surge in hacks has coincided with the growth
of these bridges.
In contrast to the network effects that develop in conventional payment networks, the crypto world
is highly fragmented. In a conventional payment network, a platform gains more users as more
individuals use it. T rust and affordability are essential to such platforms. Contrarily,
cryptocurrency's propensity for fragmentation and excessive fees is a fundamental structural fault
that disqualifies it from serving as the basis for the next generation of money.
High price correlations between various cryptocurrencies and blockchains might be caused by
speculation. Increased demand drives up prices even further. Strong price co-movement is present.
93
When the rate of new users suddenly declines, there are significant worries about what would
happen to a system that depends on selling new coins.
The DeFi Decentralization Illusion and the Role of Exchanges
T he DeFi ecosystem exhibits a propensity toward centralization despite its name. Voting is used to
make a number of important decisions among the owners of "governance tokens," which are
frequently given to developer teams and early investors and are thus highly centralized.
Since it is impossible to specify in contracts what to do in every scenario, conflicts must be settled
by some central bodies.
Additionally, aiming for increased throughput and speedier transactions, newer blockchains typically
rely on concentrated validation processes.
Incentives conflicts and hacking danger arise as validators become more centralized.
Furthermore, there are currently no regulations governing the screening of Oracle providers, and
anyone in control of Oracle can undermine the system by reporting inaccurate data.
T he cryptocurrency market is likewise centralized, with investors favoring centralized exchanges
(CEXs) over decentralized ones (DEXs). Similar to traditional banking, CEXs keep off-chain records
of the orders that traders have posted. Due to their cheaper expenses, CEXs also draw greater
trading activity than DEXs. Since 2020, CEXs have experienced significant expansion and have
attained quantities that qualify them as important from the perspective of financial stability.
Before adopting relevant regulatory regulations, it is necessary to make a fair assessment of the
parallels and divergences between the crypto market and traditional finance.
Regulatory Approaches to Crypto Risks
To address the immediate risks in the cryptocurrency monetary system, regulatory action is
required.
94
Authorities need to take regulatory arbitrage seriously. T hey should make sure that crypto and DeFi
operations adhere to the legal requirements for similar traditional activities, operating under the
guiding premise of "same activity, same risk, same regulations." T he recent collapse of numerous
stablecoins has brought attention to how urgent the situation is.
To promote the integrity and safety of the financial and monetary systems, policies are required. A
fine or closure should be imposed on cryptocurrency exchanges that conceal the identities of parties
to transactions and disregard fundamental know-your-customer (KYC) and other Financial Action Task
Force (FAT F) rules. T hey could otherwise be used to dodge taxes, finance terrorists, or get around
economic restrictions. Similarly, banks and credit card firms need to demand user identity and carry
out KYC compliance.
Consumer protection laws. Investors ought to be able to invest in riskier securities, such as
cryptocurrencies, but there needs to be sufficient disclosure. T his entails sound regulation of the
frequently deceptive advertising of digital assets. Front-running-like behaviors can necessitate the
application of innovative legal strategies.
T he exposure of banks and nonbank financial intermediaries to the cryptocurrency ecosystem poses
dangers to the stability of the financial system that must be reduced by central banks and regulators.
T raditional financial institutions are investing in cryptocurrencies at a rapid rate, which means that
shocks to the cryptosystem might have a ripple effect. Large traditional banks have so far only had
minor exposures, and their direct investments in businesses engaged in the cryptocurrency markets
are still modest when compared to their total capital. To address these risks, sound guidelines for
bank exposures to cryptocurrencies must be implemented.
It is crucial to discover regulatory entry points and close data gaps. A multitude of new centralized
intermediaries have popped up as a result of the cryptocurrency market's expansion. T he traditional
financial institutions and these centralized entities serve as a natural entry point for regulatory
responses.
T he worldwide nature of crypto will necessitate collaboration across all regulatory fields. In order to
sanction non-compliant actors and platforms, authorities may need to actively exchange information
and conduct coordinated enforcement measures.
95
Crypto’s Lessons for the Monetary System
Overall, the cryptocurrency industry offers a glimpse of exciting technological potential, but it is
unable to achieve all the major objectives of a digital monetary system. It has flaws such as stability,
effectiveness, accountability, and integrity that legislation can only partially resolve. Fundamentally,
cryptocurrency and stablecoins result in a fragmented and weak monetary system that comes from
the economics of incentives rather than technological limitations.
T he goal is to harness the beneficial cycle of network effects by not only enabling valuable
functionalities like programmability, composability, and tokenization but also putting them on a more
secure base. Central banks are utilizing the best aspects of new technology to serve the public good,
along with their attempts to regulate the crypto universe and address its most pressing issues.
Vision for the Future Monetary System
New technical advancements and a more accurate representation of central bank money at its core
should combine to create the future monetary system. T he benefits of new digital technologies can
therefore be gained through interoperability and network effects because they are rooted in trust in
the currency.
As one of its primary functions is to issue central bank money, which acts as the basis of the future
monetary system and the unit of account in the economy, central banks are ideally positioned to
provide it.
Using its balance sheet, the central bank's other function is to provide the means for the ultimate
finality of payments. It’s a trusted middleman who debits the account of the ultimate payer and
credits the account of the ultimate payee.
Another function of the central bank is to ensure enough liquidity available for settlement to support
the smooth operation of the payment system. L liquidity provision ensures no bottlenecks will
obstruct the smooth operation of the payment system.
Protecting the integrity of the payment system through regulation, supervision, and oversight is the
central bank's other responsibility. T he central bank is in a good position to provide the groundwork
96
for cutting-edge services in the private sector thanks to its interconnected roles.
T he future monetary system expands on these central bank functions and responsibilities in order to
provide room for new capabilities of central bank money and cutting-edge services to be built on top
of them. New private applications will be able to function on more advanced technology
representations of central bank money rather than stablecoins. T hus, numerous new activities can
be supported by innovations at the central bank.
Components of the Future Monetary System
T he future monetary system will be based on the tried-and-true division of labor between the central
bank, which supplies the framework of the system, and the private sector organizations, which
handle customer-facing operations. Additionally, new standards can be created, like application
programming interfaces (APIs), to dramatically improve the interoperability of services and related
network effects.
T his vision includes elements at the wholesale and retail levels that make a variety of new features
possible. At the wholesale level:
Programmabi l i ty. It can facilitate transactions between financial intermediaries and provide new
capabilities. Using permissioned distributed ledger technology (DLT ), CBDC transactions allow
programmability and settlement, enabling transactions to be conducted automatically when
predetermined conditions are met.
Composabi l i ty. make it easier for transactions to be composed by enabling the combination and
execution of a variety of different functions.
A wi der range of fi nanci al i ntermedi ari es. New capabilities not only enable a far larger range
of financial intermediaries to participate in transactions but also allow for an increase in the types of
transactions.
Mul ti -CBDC arrangements. Additionally, Central Bank Digital Currencies (CBDCs) collaborate
internationally through multi-CBDC agreements, including various central banks and currencies.
Tok eni zati on. When deposits are tokenized, they are decentralized, settled, and given a digital
97
representation on the distributed ledger technology (DLT ) platform. T his might make it easier to
exchange new technologies, including fractional ownership of stocks and other assets, opening the
door to creative financial services that go far beyond simple payment processing.
At the retail level:
Interoperabi l i ty. Users of one platform can send messages and commands to others that are linked
to it with ease through APIs. Retail innovations encourage more competition, decreased costs, and
increased financial inclusion in this way.
Instant payments. Households and businesses can easily access retail CBDCs. T hrough various
interfaces and competing private Payment Service Providers, they enable immediate payments
between end users.
Data archi tecture. T he Central Bank Digital Currencies (CBDCs) are backed by a data
architecture that includes digital identity and APIs that allow for safe data interchange, enabling more
user control over financial data.
Open pl atform. T hey facilitate lower costs in payment services by fostering efficiency and better
competition among private sector PSPs through the provision of an open platform.
Incl usi ve desi gn. Both can help financial inclusion for people who do not already have access to
digital payments through inclusive design elements.
A Metaphor for the Future Monetary System
T he central bank serves as the solid base of the metaphorical tree that represents the future
monetary system. T he tree metaphor illustrates the idea that the monetary system is founded on
payment finality through eventual settlement on the central bank's balance sheet.
T he central bank-based monetary system fosters a thriving ecosystem of participants and activities
where rival private sector Payment Service Providers can employ creativity and innovation to
better serve users.
When viewed from a distance, the world's monetary system can be compared to a forest, whose
canopy makes cross-border and cross-currency activities possible. Infrastructures like multi-CBDC
98
(Central Bank Digital Currencies) platforms function as crucial new system components in the
canopy.
Innovation is crucial. For private innovation to serve the public good, the fundamentals must be done
correctly. Public infrastructures can enhance the payment system by utilizing many of the purported
advantages of cryptocurrencies without the downsides, as demonstrated by ongoing work at central
banks. How central banks may assist interoperability and data governance is demonstrated through
wholesale and retail CBDCs as well as open banking initiatives.
Wholesale CBDCs and Tokenized Money
A Central Bank Digital Currency (CBDC) is a digital payment instrument that is directly owed to the
central bank and is valued in the country's unit of account. Retail CBDCs are available to both
individuals and companies. However, unlike domestic commercial banks, wholesale CBDCs provide
additional payment and settlement capabilities to a considerably wider range of intermediaries,
potentially spurring innovation.
Multi-CBDC systems involving several central banks and currencies can benefit from decentralized
governance. Functions such as self-executing smart contracts are essential because they enable
users to limit the settlement of their transactions to the event that certain predefined conditions are
met (programmable). T hrough such automation, payments, and delivery of securities can be done
only all at once or not at all, accelerating settlement and reducing counterparty risk.
Wholesale CBDCs have the advantage of potentially being accessible to a far broader range of
intermediaries than domestic commercial banks. By allowing nonbank PSPs to conduct CBDC
transactions, competition, and vitality could increase significantly.
Payments could be finalized with wholesale CBDCs. In a digital system, establishing the source or
"provenance" of the transferred funds is necessary to ensure that payment is genuine. Cryptography
is used to conceal real names while openly displaying the complete history of all transactions made
by all parties.
T he tokenization of regulated financial instruments, including retail deposits, can be supported by
99
central banks. Commercial bank deposits can be represented digitally through tokenized deposits.
Tokenized deposits would be programmable, "always on" (24/7), and covered by deposit insurance,
making them suitable for a wider range of retail payment applications, such as autonomous
ecosystems. T his approach could make it easier for other financial assets, like stocks or bonds, to be
tokenized, enabling fractional ownership of those assets.
One potential tokenized deposit system would include a permissioned platform that keeps track of
every transaction in tokens produced by the participating institutions. Retail investors (depositors)
would store tokens in digital wallets and send tokens between wallets to make payments. T his might
take place concurrently as a result of smart contract-enabled single atomic transactions. Digital
representations of bonds and stocks might potentially be possible with the same system.
In autonomous ecosystems, programmable CBDCs might also facilitate machine-to-machine
payments. Machines can manage their own budgets and make direct purchases from one another for
goods and services. T heir integration will enhance the need for programmable money and smart
contracts, lowering any settlement risk. T his might result in huge efficiency savings, for instance, in
the goods logistics industry, where transactions are still primarily paper-based and can take several
days.
T he advantages of atomic settlement and open-source protocols can coexist peacefully, with central
banks serving as the main hubs for validation.
Retail CBDCs and Fast Payment Systems
Wholesale and retail CBDCs have a lot in common. Retail CBDCs provide consumers and companies
with digital access to money from the central bank. Retail-facing payment services are provided by
PSPs, both bank and nonbank. T hus, retail CBDCs are occasionally referred to as "digital cash." As
transfers take place in real-time or close to real-time, on an almost 24/7 basis, they have great speeds
and availability.
Contrary to crypto, which needs high rents, has limited scalability, and is congested, Central Bank
Digital Cryptos and retail Fast Payment Systems (FPS) provide broader use, which lowers costs and
results in better services.
100
Retail Fast Payment Systems (FPS) have already made notable strides toward lowering costs and
promoting financial inclusion for the unbanked, particularly in Brazil, where two-thirds of the adult
population use their retail FPS Pix.
Retail CBDCs can be created to assist financial inclusion by examining retail CBDC design elements
that address particular barriers to financial inclusion, such as through novel interfaces and offline
payments. T he cost of payment services for the unbanked can be decreased by central banks
through tiered CBDC wallets with simpler due diligence for users transacting in lower values,
promoting more access to digital payments and financial services.
As every transaction in the digital economy leaves a trace, generating issues with privacy, data
misuse, and personal safety, retail Central Bank Digital Cryptos (CBDCs) and Fast Payment Systems
(FPSs) can be created with privacy protection and improved user control over data in mind. Since
there isn't a single, comprehensive record of every transaction in conventional payment systems,
individual Payment Service Providers (PSPs) have more control over data. Every PSP, however, only
records its own transactions. Even the central operator is unaware of all payments in full. T hus, the
promise of confidentiality by the central operator and the mix of segregated record-keeping are used
to protect the privacy of payments.
Crypto advocates claim permissionless blockchains give consumers back control over their personal
data, yet this poses serious threats to users' privacy and integrity. Retail FPSs and CBDCs' underlying
structures can allow users control over their personal data while protecting their privacy and
promoting consumer welfare. Additionally, central banks can genuinely build systems in the public
interest because they have no financial interest in personal data.
Systems that provide law enforcement authorities with access to information while maintaining the
necessary legal protections can be created with clear mandates and public accountability. T hese
methods are currently being considered for retail CBDCs and are already standard practice in the
form of bank secrecy rules.
Retail CBDCs and FPS have the potential to enhance accountability in comparison to the current
system and the crypto universe. T he role of the central bank in retail payments needs to be
discussed publicly as a result of new systems, and legal regulations will need to be modified in order
for them to operate. Private service providers would be integrated into a strong regulatory and
101
oversight framework under a system based on public infrastructure.
102
Question
Jessie, a risk manager at a venture capital firm, is evaluating potential investments in
crypto and decentralized finance (DeFi) start-ups. She recognizes that these
technological innovations can revolutionize the financial industry. However, she must
also take into account their potential risks and limitations. As part of her analysis, she is
considering the structural integrity and robustness of the technologies powering these
potential investments.
From the following choices, which statement most accurately captures Jessie's
concerns about the possible limitations of crypto and DeFi technologies?
A. T he presence of self-interested validators in a crypto system automatically ensures its
safety and integrity.
B. T he limited scalability of blockchains is an indicator of their secure nature, making
them ideal for all financial transactions.
C. T he fragmentation of the crypto universe, combined with the so-called scalability
trilemma, underpins inherent limitations in blockchain systems.
D. T he "cross-chain bridges" between different blockchains guarantee interoperability
and completely eliminate the risks of hacking and theft.
Solution
T he fragmentation of the crypto universe, combined with the so-called scalability
trilemma, underpins inherent limitations in blockchain systems. T his is because the
proliferation of different cryptocurrencies (fragmentation) could reduce overall
efficiency and compromise interoperability. T he scalability trilemma underscores that
blockchain systems can only optimize two out of the three fundamental properties:
security, scalability, and decentralization. Hence, a system may offer excellent security
and decentralization but face challenges in scaling up to accommodate large numbers of
103
transactions. T hese combined issues present significant potential limitations of
blockchain technology.
A i s i ncorrect as the presence of self-interested validators does not automatically
ensure the safety and integrity of a crypto system. Validators in a pseudo-anonymous
crypto system have no reputation at stake and cannot be held accountable under the law,
and must be incentivized through monetary rewards to maintain the system's integrity.
B i s i ncorrect as the limited scalability of blockchains, while enhancing security to
some extent, is not ideal for all financial transactions. T he scalability limitations result in
system fragmentation and high transaction fees, posing significant challenges for wide-
scale adoption.
D i s i ncorrect as "cross-chain bridges" do not completely eliminate the risks of hacking
and theft. T hese bridges often rely on a small number of validators, and their use has
been associated with several high-profile hacks due to weaknesses in governance.
104

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FRM Part II Exam

Study Notes - Current Issues in Financial Markets

Last Updated: Jul 27, 2023

prohibited. Infringers will be prosecuted in their local jurisdictions. ”

153 - Machine Learning and AI for Risk Management 3

describe the techniques used within each category.

techniques in risk management.

to improve risk management.

Categories of Supervised Learning

Regression Machine Learning

employment status, credit history, and other outstanding liabilities.

variables found to have explanatory power.

a smaller number of uncorrelated variables called principal components. T he objective of PCA is to

influence their credit repayment risk.

smaller set of synthesized variables – the 'principal components.'

might not always have a clear or intuitive meaning.

that specifically targets those account holders.

Categories of Unsupervised Learning

deemed spam, it is also likely to be spam.

they should get.

The Application of AI and Machine Learning Techniques

distress and bankruptcy prediction and neural network algorithms.

traditional benchmark models regarding prediction accuracy. T he nonparametric machine learning

Stress testi ng mark et ri sk model s to di scover hi dden or emergi ng ri sk s: One

can be incomplete, false, invalid, or even incorrectly specified in terms of parameters.

model testing for deviations, and model validation.

Understandi ng the i mpact of a fi rm's tradi ng acti vi ti es on mark et pri ci ng: AI

price, particularly in illiquid markets.

in underlying trading patterns.

AI and machine learning can help firms to:

Identify effective risk mitigation strategies.

Find instruments that can facilitate shifting or trading risk.

breaches after they have occurred.

For risk management, AI and machines offer several key benefits:

combined to form new variables that unravel key relationships.

through greater (predictive) insights and risk visibility.

The Limitations and Challenges of Using AI and Machine

Avai l abi l i ty of sui tabl e data: T he effectiveness of AI and machine learning

sometimes on different systems, creating barriers to accessibility and integration. Internal

Avai l abi l i ty of sk i l l ed staff: T he successful implementation of AI and machine

proficiently implement and utilize these techniques is a time-consuming endeavor, despite

of these skills, such as India.

management solution; instead, it's an ongoing process requiring regular evaluation to

to a loss of $440 million within 45 minutes, illustrates this risk vividly.

laws becomes increasingly challenging and important.

application of these techniques?

liquidity of CDS instruments in the secondary market.

interactions in the context of the CDS market.

audit trails and ensuring regulatory compliance.

credit events and default costs in the CDS market.

informed investment decisions in the CDS market.

Options A, B, and C, although plausible applications of AI and machine learning

Describe practices financial firms can adopt to mitigate AI risks.

large. Such risks may originate from:

Data used to train the AI system.

Usage of the AI system.

Poor governance of the system.

and trust, and compliance (people) risks.

Data Related Risks