Climate risks and financial stability: Evidence from the European financial system

Abstract

Climate-related risks have become a major concern for financial regulators and can pose a significant threat to financial stability. In this paper, we first propose a theoretical framework for the transmission of climate risks to financial institutions and the financial system. We then estimate the influence of physical and transition risks on the European financial system through bank-level and system-wide measures of financial stability. We find that Scope 3 greenhouse gas emissions, chronic and acute climate risks negatively affect financial stability at both the financial institution and system levels. Temperature anomalies, heat waves, wildfires and droughts are among the most significant risks. As Europe warms twice as fast as the rest of the world, our theoretical and empirical results urge regulators to mandatorily require the assessment and disclosure of corporate climate risks to allow banks to adjust their prudential capital requirements.