Climate disasters are weakening the banking sector

Climate disasters are shaking the global economy and weakening the banking sector, finds a study by four economists, including Professor Rong Ding at NEOMA Business School.

By examining economic and climate data, the researchers show that these events increase the risk of loan defaults and put financial markets under strain, exposing banks to unprecedented challenges.

The more a bank is exposed to borrowers affected by disasters, the greater the risk of non-repayment, destabilising the entire sector.

Ding and his co-authors focused on examining interstate syndicated loans, where multiple states join together to borrow large sums. They find this mechanism can amplify crises and trigger a domino effect with systemic repercussions if disasters are poorly anticipated.

By combining indicators of damage caused by climate disasters (death toll, financial losses, etc.) with tools assessing the risk of banking defaults, the researchers were able to quantify precisely the effects of climate hazards on the solvency of financial institutions.

Their goal is to develop a climate risk exposure index to identify the most vulnerable regions and anticipate banks’ difficulties in recovering loans in these areas.

The results are unequivocal: when climate risk exposure increases by one standard deviation (a statistically significant unit of measure), all indicators turn red for creditor institutions.

The researchers highlight a rise in the expected shortfall—the average loss a bank can expect in worst-case scenarios—of 14.7% in the short term and 1.3% in the long term. The value at risk, the maximum probable loss, increases similarly, as does the likelihood of financial system destabilization (systemic risk contribution).

Therefore, they warn the statistical correlation between climate disasters, unpaid loans, and economic destabilization is a cause for concern.

When a disaster strikes borrowers, the researchers suggest banks could improve their resilience by temporarily reducing lending activity and setting aside cash reserves to offset future losses. This creates a financial cushion that helps to absorb the consequences of climate disasters.

“The future requires a more forward-thinking policy adapted to new climate risks. The systematic integration of a climate risk exposure index into financial institutions’ assessments could be a significant strategic lever,” says Ding.

This study was published in The European Journal of Finance.

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For more information, a copy of the study, or to hear from Professor Rong Ding, contact Jamie Hose at BlueSky Education on jamie@bluesky-pr.com, or call +44 (0)1582 790 706.