Impact of climate policy transition and physical risk on financial stability of US banks: a focus on top environmental-performing institutions

Purpose We examine how climate policy transition risks affect both the instability and profitability of US banks. Specifically, the study examines how climate policy uncertainty (CPU) and energy prices as a proxy for environmental policy stringency and climate risk influence US banks. The analysis also focuses on high environmental rating banks, questioning whether their environmental performance enhances resilience to transition and physical risks. Design/methodology/approach We utilize a dynamic panel dataset of over 4,400 observations, using quarterly data of the largest 100 US banks between 2011 and 2022. The two-step dynamic panel generalized methods of moments (GMM) estimation techniques are applied. The authors rerun the model for different dependent variables to test the validity of the estimations. A difference-in-differences (DiD) identification strategy with standard dynamic panel data methods, two-step system and difference GMM is complemented to address endogeneity and persistence. Robustness is established via jackknife corrections, placebo tests and nonlinear (quadratic) specifications. Findings The study reveals that energy prices, reflecting stricter environmental policies, mitigate the destabilizing effects of CPU and physical risks, supporting the hypothesis of an antagonistic relationship between the variables. The results from the base models and robustness tests consistently confirm the hypothesized link between climate policy stringency and banking stability, adding to the empirical literature on climate-stability interdependence. Research limitations/implications The results need to be cast in the appropriate context, as energy prices, although serving as a proxy for environmental policies solely, do not fully reflect the stringency of environmental policies. Alternative proxies and placebo tests mitigate the aforementioned limitations. Practical implications The study provides evidence that the corresponding environmental policies mitigate climate policy transition risks. This actuates regulators, policymakers and financial institutions seeking to strengthen stability in the face of climate risks. Originality/value The study provides new evidence into the nexus between transition risks, energy prices, physical risks and banks’ soundness. The current empirical studies for CPU and impact have brought mixed evidence. The energy price effects are not contextualized and integrated. The authors find consistent results, providing a broad and causal exploration.