Total climate change risk and banks' loan portfolios: Fresh evidence and extensions

The transition towards net-zero conditions needs large investments that are expected to generate a strong demand for bank loans and other financing. Such conditions pose risks not only to firms themselves, but also to banks that provide financing means to them. Climate risk also heightens default risk by weakening borrowers' earnings and ability to meet obligations, incentivizing banks to restrict loan supply and avoid future default-related losses. The study exclusively focuses on banks' corporate loan portfolios with the analysis exploring the simultaneous influence of physical and transition risk on banks' loan portfolios exposure, while it further investigates whether the badly exposed to transition policies industries still have access to financial markets. Employing quarterly data on U.S. banks' loan portfolios, quantifying bank exposures to both physical and transition risks, through the development of industry-specific estimates of climate policy impacts on economic performance (profitability) and mapping sectoral vulnerability measures to bank loan portfolios through detailed exposure matching, and using fixed effects panel methods, spanning the period 2012 to 2023, we manage to quantify the exposure to both physical and transition climate risks. The findings indicate that both categories of risk, transitional policy-driven shifts and physical hazards, are projected to amplify the vulnerability of bank loan portfolios over time. The results document that not only the transition, but also the physical risks are expected to increase the exposure of banks' loan portfolios. An increase of physical risks by 1 % is expected to increase the vulnerability of bank loan portfolios by 5 %-12 %, depending on the policy scenario followed. The results survive certain robustness checks, such as endogeneity tests and alternative measures of physical risks. Finally, the analysis highlights that in terms of the connection between the exposure of banks' loan portfolios and the access to funding of those firms, the financial access variable exerts a significantly positive impact on banks' loan exposure. The results illustrate how climate change risks, both physical and transition related, affect bank loan portfolios, highlighting their systemic impact on the banking sector. The results offer invaluable insights for both the banking industry and regulatory authorities in navigating the dynamic environment of sustainable finance. Important recommendations are proposed on how banks might survive and prosper in the face of unprecedented environmental challenges.