Climate policy and banks’ portfolio allocation

How do banks respond to transition risk and which mechanisms drive this response? We shed new light on this question using data on granular international large exposures of UK banks. Climate policy is the main source of transition risk we use. We find that an increase in climate policy stringency on average leads to a decline in the share of lending that is exposed to transition risk. However, this finding is not uniform across banks: banks with a lower initial exposure to transition risk decrease their transition-risk exposure by more and increase their transition-aligned exposure, while banks with a high initial exposure to transition risk further increase their exposure to those sectors. We also find evidence supportive of outward international spillovers through banks' cross-border lending portfolios: banks increase transition risk-exposed lending to a given country if climate regulation gets tighter in other countries banks have such exposures to.