When Nature Strikes: Banking Stability, Carbon Pricing, and Proactive Climate Risk Management

Abstract

This study examines the impacts of physical climate risks on banking stability using a global panel dataset (2005-2023). We analyze natural disasters, climate vulnerability and readiness, carbon pricing policies, and macroeconomic conditions using fixed-effects regression models. Our findings provide mixed evidence on the relationship between natural disasters and banking stability. Natural disasters typically increase nonperforming loans (NPLs), reduce liquidity, and lower capital adequacy, though effects vary substantially by context. Climate vulnerability significantly exacerbates liquidity pressures and equity reductions but also generates unexpected short-term stabilizing effects, possibly due to regulatory interventions. Climate readiness demonstrates selective effectiveness, moderating profitability volatility and enhancing liquidity and capital stability in certain contexts. Carbon pricing policies initially induce transitional challenges but yield substantial long-term stability benefits by incentivizing banks to shift toward sustainable asset portfolios. Macroeconomic conditions, notably GDP per capita and government debt levels, further moderate banks' resilience to climate shocks, revealing complex interactions that simultaneously amplify and mitigate banking vulnerabilities. These findings provide policy-relevant evidence, highlighting the necessity for tailored frameworks and context-specific risk management strategies that effectively balance transitional economic impacts with long-term financial resilience objectives.