Climate-related risks and loan quality in Europe: Do institutional quality, environmental commitment, and bank size matter?

The paper examines how climate-related risks impact credit quality in the European banking sector, utilizing fixed-effects models on a sample of 127 banks across 27 European countries from 2005 to 2023. More specifically, this research assesses the impacts of transition risk and physical risk, taking into account structural, institutional, and sustainability variables. The results indicate that transition risk has a significant impact on degrading credit quality, whereas physical risk has a minimal impact on credit risk. However, this effect is attenuated by the presence of institutional quality and the development of ESG strategies, particularly the publication of sustainability reports. Additionally, our results indicate that institutional quality mitigates the negative impact of climate-related risk on loan quality, suggesting that institutional quality plays a significant role in enhancing financial resilience. Furthermore, robustness tests with alternative proxies and samples disaggregated by bank size reveal a greater vulnerability of small banks and a more effective response in ESG-oriented banks. The work’s innovative contribution lies in integrating environmental risks, institutional indicators, and ESG practices within a single empirical framework, applied to the stability of bank credit. The results provide new evidence for prudential regulation and demonstrate that the climate transition poses an environmental challenge and a crucial lever for rethinking risk management in the European financial system. EFM CODE: 510 JEL CODE: G210, Q540 • Transition risk impairs credit quality in EU banks, especially in emission-intensive sectors. • Strong institutions significantly mitigate the effects of climate risk on bank loan portfolios. • ESG commitment reduces loan risk but may exacerbate climate risk when not thoroughly integrated. • Small banks are more vulnerable to climate shocks; institutional quality supports resilience.