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. These findings raise the possibility that overly stringent green finance policies could lead to a disorderly transition. In addition, measures that restrict banks' exposure to carbon-intensive counterparties, both directly and indirectly, may lead to less lending to the real economy and higher lending rates. The latter increase, in turn, could lead to significant credit losses, reduced bank profitability and other spillover effects with the potential to undermine systemic resilience. 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. Our findings have critical policy implications for public authorities formulating green financial policies to achieve the goals of the Paris Agreement.