Climate-Related Financial Policy and Systemic Risk

We examine the relationship between climate-related financial policies (CRFPs) and banks' systemic risk. Using a sample of 458 banks in 47 countries over the period 2000-2020, we document that more stringent CRFPs are detrimental to overall financial stability and contribute to increased system-wide distress, where excessive regulatory constraints may impose burdens on banks. Decomposing systemic risk shows that stricter climate-related financial policies raise banklevel volatility but not interbank correlation, indicating that higher systemic risk stems from increased individual bank fragility rather than stronger synchronization. We investigate the banklevel transmission channels through which climate-related financial policies may contribute to higher systemic risk. Tighter policies are associated with slower loan growth, lower profitability, an increase in non-performing loans and compressed net interest margins, as funding costs rise faster than lending rates. At the same time, capital adequacy ratios decline, indicating mounting balance sheet pressures. However, the implementation and ratification of the Paris Agreement, more robust adaptation strategies to cope with climate shocks and a higher incidence of natural disasters and a larger number of people affected by extreme climate events may counteract the amplifying effects of CRFPs on systemic risk. Moreover, banks with stronger environmental, social, and governance (ESG) commitments experience less systemic distress when exposed to green financial policies.