Uncovering transition risk: A new stress testing approach for the banking sector

This paper examines the impact of transition risk on the stability of the European financial system. Using a novel dataset, we assess the systemic relevance of euro area banks’ exposures to climate-relevant sectors as of 2024. By clustering banks into communities, we find that those more exposed to transition risk tend to have smaller total exposures towards non-financial corporation and greater sectoral diversification. We then introduce two climate stress-test methodologies: one based on a policy shock and another linked to a regulatory CO2 reduction target. The latter shows that shocks in carbon-intensive sectors propagate through industrial interdependencies, affecting less-intensive sectors and amplifying impacts on highly intensive ones. Under mild scenarios, voluntary capital buffers absorb losses in most banks, amounting to EUR 104 billion and EUR 54 billion for the two methodologies, indicating overall system resilience. In extreme scenarios, however, losses rise to EUR 209–220 billion, with capital depletion of 2.4–2.6% of risk-weighted assets; voluntary buffers cover losses in 85–90% of banks. The CO2-based approach highlights the importance of indirect input–output spillovers, which account for 73% of total losses.