The ecosystem service degradation sensitivity indicator (EDSI): A new framework for understanding the financial risk repercussions of nature degradation

This paper introduces a new framework for integrating dependence on nature (ecosystem services) and the degree of nature degradation in estimations of credit risk-related losses for banks. The framework brings the field of nature-related financial risks forward by proposing a capital-based sensitivity indicator to nature degradation, thereby moving from an “exposure” approach to a “financial risk” approach. This ecosystem service degradation sensitivity indicator (EDSI) shows how much of a bank’s available capital buffer on top of its minimum requirements is lost due to a shock on nature. It enables cross-bank and cross-country comparison of potential financial losses related to nature degradation. Our results indicate that incorporating nature degradation into financial risk estimates adds an important - and currently missing - layer of risk and offers additional differentiation in capital impact among banks and countries. While in this paper the framework uses hypothetical shocks on nature and can therefore only produce comparative sensitivity indicators, upon calibrating a shock on different ecosystem services the framework can be used to stress-test financial institutions’ solvency position.

Keywords: nature degradation; ecosystem services; biodiversity loss; dependence score;financial stability; risk; credit risk losses; Merton model
JEL codes G21; G28; Q57

Working paper no. 814