The impact of climate risk on bank lending, pricing, and resilience

The impact of climate risk on bank lending, pricing, and resilience
In the aftermath of the 2015 Paris agreement, a number of calls for action have been issued for banks to consider the effects of climate risk on their financial risks (e.g., NGFS, 2019). Such effects may occur if, for instance, an extreme weather event (e.g., flood) impacts the ability of borrowers to repay their loans and/or the value of a loan collateral; similarly, an acute weather event may ignite bank runs on deposits; also, the transition to a low-carbon economy may impose large costs on polluting industries, adversely affecting their credit quality (BCBS, 2021).
Against this backdrop, this research project aims to contribute to the emerging literature studying the effects of climate risk on bank lending, pricing and resilience (Berg & Shrader, 2012; Javadi & Masum, 2021; Klomp, 2014).
First, we expand the literature by studying the effects of wildfires in Portugal on bank lending. Particularly, we are keen on understanding whether bank lending to firms affected by large wildfires is significantly different than that of comparable firms in unaffected regions. To address this issue, we employ a diff-in-diff approach to a unique ‘natural experiment’ setting: the large wildfires that took place in 2017, in Portugal. Our data is comprised of geospatial information on wildfires provided by ICNF and loan-level data curated by Banco de Portugal (BPLIM).
Second, we study the effects of several climate risks on bank pricing in Portugal. Namely, we wish to examine whether credit spreads are higher for firms more exposed to climate risk vs comparable firms with lower exposure to climate risk, and whether banks’ prior experience with climate risk mediates this relationship. To address these issues, we draw on historical data from IPMA on extreme climate events (e.g., wildfires, droughts, floods) and from BPLIM regarding loans (since 1999).
Lastly, we examine the effects of climate risk on bank resilience. Specifically, our goal is to check the impact of alternative climate change and carbon emission scenarios on banks’ profitability and solvency. We do so by applying a climate stress test to Portuguese banks using data on carbon emissions from INE, and two climate scenarios: controlled emissions (RCP 4.5) and hot-house world (RCP8.5), from IPMA.
This project aims to further the development goals on the integration of climate change in national policies (ODS 13.2) and improving the regulation and supervision of banks (ODS 10.5). In a nutshell, studying climate risk and bank lending will allow us to clarify whether public support measures may be needed to foster credit access under climate shocks; examining climate risk and bank pricing may help us understand whether bank supervisors need to be more stringent regarding climate related risk management; and lastly, analyzing the effects of climate risk on bank resilience may aid supervisors and bank managers to determine adequate levels of capital to make banks prepared for adverse climate shocks.