Physical climate risk and banks’ credit risk: Worldwide evidence

This paper examines the impact of physical climate risk on banks’ credit risk and, by extension, on global financial stability. We use the S&P Physical Risk Index as a proxy for banks’ exposure to physical climate risk. Credit risk is measured using the forward-looking probability of default from the Chan-Lau and Sy (2007) model, which adapts the structural Black–Scholes–Merton framework to the banking context. Based on a worldwide sample of 374 listed banks, our results show that physical climate risk increases banks’ credit risk. This effect is particularly pronounced for banks with greater informativeness, intrinsically vulnerable, and operating in more fragile countries. The findings provide empirical support for the financial regulators’ proposal to incorporate climate risks into capital requirements to more effectively manage climate-related financial risks. Importantly, the results indicate that such regulatory adjustments should be calibrated to each bank’s specific characteristics and operating environment. • Physical climate risk increases banks’ credit risk, as measured by the forward-looking probability of Chan-Lau and Sy (2007) . • The relationship between physical and credit risk is significant for banks with greater informativeness. • Intrinsically vulnerable banks, those with weaker capitalization or greater credit exposure, are more affected by physical climate risk. • Banks operating in more fragile countries exhibit a stronger transmission of physical climate risk to credit risk.