2.3.6.2 Financial destabilisation tipping dynamic

Financial markets are increasingly conceptualised as complex network systems that can be affected by tipping points and cascades (Battiston et al., 2016). An expected function of financial markets is to aggregate individual forecasts about future profitability, and as such  to manage future risk. In theory, markets can thus adjust – more or less smoothly depending on the smoothness of individual agents’ perception changes – to foreseeable problems, similarly to traders, who reduce demand for equities in exposed companies. Financial crises are likely to result either from tipping points that defy predictions either in timing or magnitude, or from further cascade effects such as the collapse in mortgage insurance markets in the financial crisis of 2008. Indeed, the 2008 financial crisis is a good example for a tipping cascade: home-loan defaults caused a decrease in the value of collateralised debt obligations, leading to the insolvency of banks and insurers, resulting in a credit crunch, an economic downturn and ongoing repercussions that persist today (Sharpe, 2023). 

Similar dynamics will probably unfold with escalating climate change, and particularly when tipping points are breached. If the banks’ equity deteriorates due to economic imbalances reaching a certain threshold (see Chapter 2.3.6.1), secondary systemic effects would be triggered. The troubled banks would fail to meet their financial obligations to other banks and hastily sell their assets at lower prices, eroding confidence in similar banks (Chinazzi and Fagiolo, 2015; Kiyotaki and Moore, 2002; Roukny et al., 2013). Such contagion phenomena can result in a tipping point being reached, when contagion becomes self-perpetuating due to feedback loops in the system that amplify the initial shocks (Haldane and May, 2011; Gai and Kapadia, 2010; May et al., 2008). For example, a drop in asset prices can lead to margin calls, which force investors to sell more assets, which further depresses prices. This can lead to a cascade of failures across the financial system, resulting in a full-blown financial crisis, with collapsing of value of loans and of insurance companies, risking destruction of much of the value of the world’s savings pools. At least a third of these savings – around $60 trillion – is held in pension funds, paying income to pensioners and storing value for future generations as they get older (OECD Global Pension Statistics, 2021). 

Finally, if Earth system tipping points are triggered, destroying assets and the economic productivity of whole regions, we can expect rapid non-linear tipping point effects in the coupled global financial sector (Galaz et al., 2018; Battiston et al., 2017). The financial and economic system would eventually settle into a new stable phase, although this phase may be characterised by recession, high unemployment, austerity and other deteriorating economic conditions.

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