U.S. Banks’ Exposure to Climate Transition Risks

- The researchers are investigating U.S. banks’ exposure to climate transition risks and have developed a measure labelled Climate Transition Risk Exposure (CTRE)
- Findings show that average climate transition risk declined following the Paris Agreement in 2015 but is primarily due to re-balancing bank loan portfolios towards low-emission borrowers rather than decreasing loans to high-emission borrowers

A study by researchers from Frankfurt School of Finance & Management and University of Zurich and Swiss Finance Institute reveals that U.S. banks are increasingly exposed to climate transition risks. This exposure arises from the carbon footprints of their syndicated loan portfolios, highlighting the financial sector's vulnerability to regulatory changes and climate-related litigation.

The study, titled "Climate Transition Risks of Banks", presents a novel bottom-up measure for banks’ exposure to climate transition risk labelled ‘Climate Transition Risk Exposure (CTRE)’ based on the carbon footprint of borrowers of 34 major US banks.

Banks face climate change risks when lending to firms vulnerable to physical or transition risks. Physical risks involve climate-related shocks, while transition risks include regulatory changes or climate-related litigation. Both increase a borrower’s likelihood to default and the riskiness of bank lending portfolios.

Using this CTRE measure, the researchers ask, “What steps are U.S. banks actively taking to comply with the Paris Agreement and facilitate decarbonisation of the economy?”

Findings show that average climate transition risk declined following the Paris Agreement in 2015. The researchers establish that the decline in risk is primarily due to re-balancing bank loan portfolios towards low-emission borrowers rather than decreasing loans to high-emission borrowers. Banks with higher transition risks tend to provide more climate-related disclosures during earnings calls only when probed by analysts, but not voluntarily in their annual reports. Banks actively lobby against stricter climate policies if they have significant exposure to climate transition risks. Also, banks with a higher share of female board members have lower exposures to transition risks, highlighting a positive relationship between gender diversity and environmental performance.

“The study highlights the challenges banks face in managing climate transition risks, which are complex to identify, price, and hedge,” says Professor Dr Sascha Steffen. “This is due to the systematic nature of these risks, insufficient firm disclosures, and a lack of hedging instruments. As central banks incorporate climate change into their regular stress tests, the evolving regulatory environment increases scrutiny on banks' reported exposures to climate risks.”

The researchers also propose that their findings are essential for banks, regulators, and stakeholders aiming to navigate the complexities of climate transition risks and contribute to a sustainable financial future. Understanding these risks helps gauge the implications of stricter climate policies on the banking sector and financial stability.

You can find the full paper here.

About the Authors: Felix Martini, Professor Dr Sascha Steffen, and Carola Theunisz are affiliated with Frankfurt School of Finance & Management. Professor Dr Zacharias Sautner is associated with the University of Zurich and Swiss Finance Institute.