International Review of Financial Analysis 92 (2024) 103096

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International Review of Financial Analysis

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Impact of climate risk on financial stability: Cross-country evidence

Zhonglu Liu a, Shuguang He a, Wenjiao Men a, Haibo Sun b, *
a
College of Finance, Shandong Technology and Business University, Yantai, Shandong 264005, China
b
College of Economics, Shandong Technology and Business University, Yantai, Shandong 264005, China

A R T I C L E I N F O A B S T R A C T

Keywords: There is a growing awareness that climate change is a new source of risk to the financial system, but cross-
Climate change country evidence on the impact of climate risk on financial stability is lacking. This study empirically in­
Financial stability vestigates the impact of climate risk on financial stability using panel data from 2007 to 2019 in 53 countries.
National governance quality
The findings of this study reveal that climate risk negatively affects financial stability, and this adverse impact
Macroprudential policy
will show differences due to the different levels of economic development, financial development, and compe­
tition among countries. Furthermore, macroprudential policies have effectively maintained the financial stability
of countries affected by climate risk. However, the macroprudential policies imposed on borrowers are different
from balance-based and buffer-based macroprudential tools. In addition, good national governance quality can
contain the impact of climate risk on financial stability. After suffering from climate risk, strengthening political
stability, improving government efficiency, supervision, and legal system, strictly controlling corruption and
improving the right to speak and accountability are conducive to the country’s maintenance of financial stability
to varying degrees. This study not only enriches the existing research in the field of climate financial risk, but also
provides a reference for government departments to reduce the impact of climate risk and maintain financial
stability.

1. Introduction Brandi, Dzebo, & Elizalde Duron, 2022; Kimuli et al., 2021). In addition,
the Paris Climate Conference ratified the Paris Agreement, the third
Climate change is one of the greatest challenges of this century, and significant international legal instrument in human history aimed at
the current situation is unprecedented in world history (Krogstrup & tackling climate change, succeeding the United Nations Framework
Oman, 2019). According to United in Science 2021, the global average Convention on Climate Change and the Kyoto Protocol. These plans and
sea level rose by 20 cm between 1900 and 2018. It increased from 2006 practices signify the initiation of a novel framework for global climate
to 2018, at an average annual rate of 3.7 ± 0.5 mm. Moreover, between governance (Bel & Teixidó, 2020; Feng, Chang, Lin, Lee, & Lin, 2022;
2017 and 2021, the global average surface temperature has broken the Liu, McKibbin, Morris, & Wilcoxen, 2020; Pang, Liu, Hou, & Tao, 2023).
historical record. It is 1.06 ◦ C to 1.27 ◦ C higher than before industrial­ Finance plays a central role in the process of economic development,
ization. Abnormal changes in the climate system further lead to high- and the negative impact of climate change on the real economy will also
frequency and high-intensity outbreaks of extreme weather and be transmitted to financial institutions through various channels (King &
climate events on a global scale. The number of global climate disasters Levine, 1993; Stolbova, Monasterolo, & Battiston, 2018). Also, climate
has increased between 1970 and 2019. Over two million people died, change generates a series of financial fluctuations, triggers systemic
and economic losses have been estimated at US$ 3.64 trillion as a result financial risk, and endangers the safety and stability of the financial
of the global climate disaster. Puertas and Marti (2021) and Sun, Xu, sector (Cevik & Jalles, 2022; Dafermos, Nikolaidi, & Galanis, 2018). As
Wang, Li, and Zhang (2021) contended that climate disasters have noted by Dietz, Bowen, Dixon, and Gradwell (2016), climate risk could
caused serious social and economic losses. In September 2015, the be the cause of global financial assets loss as high as US$ 24 trillion.
United Nations adopted 17 Sustainable Development Goals (SDGs). Moreover, the frequency of banking crises has aggressively increased by
Many SDGs focus on the environment such as SDG 13 (Climate action), 26% - 248% due to climate change (Lamperti, Bosetti, Roventini, &
emphasizing the role of climate in global sustainability (Iacobuţă, Tavoni, 2019). In 2015, Mark Carney states that climate issues will

* Corresponding author at: 191 Binhai Middle Road, Laishan District, Yantai City, Shandong Province, China.
E-mail address: haibo_new@[Link] (H. Sun).

[Link]
Received 10 April 2023; Received in revised form 9 January 2024; Accepted 17 January 2024
Available online 21 January 2024
1057-5219/© 2024 Elsevier Inc. All rights reserved.
Z. Liu et al. International Review of Financial Analysis 92 (2024) 103096

sooner or later threaten the stability of the financial system. Annual management to evaluate the effectiveness of macroprudential policies in
Report 2021 on Climate-related Financial Risk of the Financial Stability mitigating climate risks. It systematically examines the prevention and
Oversight Council asserted that the economic and financial conse­ control impact of these policies and further analyzes the distinctions
quences of continued climate change are likely to repeatedly impact the among various types of macroprudential policy tools in managing
financial system and disrupt financial stability. The Central Banks and climate financial risks. This paper provides a theoretical reference for
Supervisors Network for Greening the Financial System (NGFS) and the financial regulatory agencies to formulate differentiated policy mea­
Financial Stability Board have identified climate change as a source of sures in response to climate change risks. Thirdly, this study in­
financial risk. The financial system is facing severe climate risk chal­ corporates the national governance system into the analysis framework
lenges. This study raises the question of how severe the climate risks of climate risk and financial stability. This approach explains the
affect financial stability. moderating role of national governance in the relationship between
Since the adoption of the UN SDGs and the Paris Agreement, central climate risk and financial stability. In this way, this study addresses the
banks and financial regulatory authorities worldwide have increasingly research gap pertaining to the role of national governance in climate risk
acknowledged the threat posed by climate change uncertainties to the prevention and control. Furthermore, it provides theoretical support for
stability of the financial system. Consequently, they have actively enhancing the climate financial risk response framework.
participated in discussions concerning climate change (Battiston, The rest of this paper is organized as follows: section two discusses
Dafermos, & Monasterolo, 2021). To mitigate climate risks and uphold and reviews the literature. In section three, research hypotheses are
financial stability, nations have implemented diverse policies like presented. Section four outlines the research model construction and
macroprudential policies. For the dominance of these policies, assessing variables. The fifth section is devoted to research analysis and results.
their actual effects is essential specifically in preserving financial system Finally, section six describes the conclusions.
stability after climate risk shocks. Moreover, countries have consider­
ably different patterns for their political, legal, and other institutional 2. Literature review
approaches, which may influence the outcomes and implementation of
climate-focused policies. The extent of a country’s national governance Firstly, this section conducts a comprehensive review of existing
capacity has a direct influence on its political ecology, rule of law, and research concerning the economic and financial impact of climate
social atmosphere. Additionally, this capacity depends on the efficiency change. Secondly, it reviews the categories of risks that climate change
of emergency response and management. This analysis proposes the affects financial stability. Lastly, it provides a synthesis of relevant
question of whether the quality of national governance impacts the studies on climate risk response measures to propose the current
relationship between climate risk and financial stability. research gaps in the field.
To address these inquiries, this paper systematically investigates the
correlation between climate physical risk and financial stability. More­ 2.1. The impact of climate change on the economy and finance
over, this paper further explores the role of national governance quality
and macroprudential policies in the prevention and control of climate Reviews of the existing literature confirm that climate changes have
financial risks. Based on the theoretical analysis, this paper employs a significant impact on the macroeconomy. As stated by Gallic and
panel data from 53 countries from 2007 to 2019 to examine the over­ Vermandel (2020), a climate risk shock is generally recognized as the
arching principle and internal mechanisms of the influence of climate important reason for economic fluctuations. Scholars prove that climate
physical risk on financial stability. The findings indicate the adverse risk can affect economic operations, cause economic paralysis, and
effects of climate risk on financial stability, albeit varying from country eventually slow down the rate of economic growth (Fang, Lau, Lu, Wu,
to country. This result is valid since it is consistent with the robustness & Zhu, 2019; Kahn et al., 2021). In addition, the negative impact of
test results which replace explained variable, handle the endogenous climate risk on the economy also reflects country heterogeneity. In
problems, and adjust the sample period. The findings also disclose that resilient or wealthy countries, climate risk is less damaging to econo­
macroprudential policies are effective in maintaining a country’s mies. On the other hand, in countries with poor adaptive capacity or
financial stability from climate risk. Balance sheet and buffer macro­ poverty, climate risk may cause permanent damage to economic growth
prudential instruments restrain financial volatility caused by climate potential (Adom & Amoani, 2021; Hsiang et al., 2017). Then, as an
risk. However, the negative impact of climate risk on financial stability important part of the macroeconomy, the financial system will naturally
has been exacerbated by macroprudential policies imposed on bor­ be affected since the economic impact caused by climate risk may
rowers. The results also reveal a good national governance system can change the value of financial assets held by enterprises and sovereign
mitigate the adverse impact of climate risk on financial stability. A good entities (Battiston et al., 2021). This impact may also adversely affect the
national governance system can enhance national stability, improve liquidity, leverage, and solvency of financial institutions, resulting in
government efficiency, supervision and legal system, strictly control financial risk (Chenet, Ryan-Collins, & van Lerven, 2021; Roncoroni,
corruption, and improve the right to speak and accountability. This is Battiston, Escobar-Farfán, & Martinez-Jaramillo, 2021). Also, the
conducive to the country’s financial stability after suffering from climate interconnection within the financial system will further infect financial
change. Given this perspective, this study enhances the theoretical risk. This will form negative feedback on the real economy, leading to a
comprehension of the relationship between climate risk and financial cycle of vicious shocks (Battiston, Caldarelli, May, Roukny, & Stiglitz,
stability. Moreover, the findings of this research hold significant prac­ 2016; Duan, Yuan, Cai, & Wang, 2022). In general, climate risk shocks
tical implications by offering decision-making guidance for financial the real economy and then disrupts the functioning of the financial
regulatory authorities in the design and adjustment of regulatory pol­ system through complex transmission and feedback mechanisms.
icies, thus bearing practical significance.
This paper makes some significant contributions to the literature. 2.2. Risk categories of climate change impacting financial stability
Firstly, this paper establishes an inclusive theoretical analysis frame­
work for the nexus of climate physical risk and financial stability. This Due to the long-term and gradual nature of climate change, its
framework systematically deconstructs the formation mechanism of negative impact on financial stability is characterized by complexity,
climate financial risk across multiple dimensions, and delves into the persistence, and extensiveness, which will trigger systemic financial risk
pivotal factors that influence its development. Moreover, adopting a (Javadi & Masum, 2021; Li & Pan, 2022). Climate change may affect the
transnational approach, this study performs an empirical test to enrich stability of the financial system mainly through physical and transition
both the theoretical and empirical analysis of climate financial risks. risks (Nguyen, Diaz-Rainey, & Kuruppuarachchi, 2023). Specifically, the
Secondly, this research has a perspective of proactive financial risk physical risk is physical damage and casualties directly caused by

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climate change (Lee, Wang, Thinh, & Xu, 2022). Moreover, physical risk stability needs further discussion.
can be subdivided into short-term extreme weather events and long-
term climate change (Adom & Amoani, 2021; Venturini, 2022). Tran­ 3. Research hypothesis
sition risk is caused by changes in policy measures, scientific and tech­
nological innovation, and market sentiment after climate change (Diaz- The impact of climate physical risk on financial stability is mainly
Rainey, Gehricke, Roberts, & Zhang, 2021; Reboredo & Ugolini, 2022). reflected in two aspects. First, extreme weather events such as floods,
It is a sacrifice made to deal with climate change (Diluiso, Annicchiarico, droughts, and hurricanes caused by climate change impact the real
Kalkuhl, & Minx, 2021; Dunz, Naqvi, & Monasterolo, 2021). economy in the short term, causing financial turmoil. Second, rising
global temperatures and sea levels caused by climate change will affect
2.3. Relevant research of climate financial risk response measures economic development in the long-term. These changes will be further
transmitted to the financial system and impact financial stability. These
With the increasingly severe impact of climate risk, relevant scholars two aspects first affect the real economy, and then transmit to the
propose a series of policies and measures to focus on climate risk. As a financial system through the real economy. Fig. 1 shows the influence
powerful means to deal with climate change and maintain ecological mechanism diagram and specific analysis is as follows:
balance, green finance has become a hot spot of governance in various Underwriting risk channel. Climate disasters are interconnected with
countries (Ren, Zhang, Yan, & Gozgor, 2022). The specific measures insurance protection mechanisms (Pan, Liu, & Cheng, 2022). The
include differentiated capital requirements, strengthening the guidance heightened frequency or intensity of climate disasters can activate in­
and control of the flow of credit funds, greening the balance sheet of the surance liability, leading to substantial compensation obligations. Based
central bank, and providing green special financing directly to the on the theory of insurance claims, insurance companies encounter sig­
government (Campiglio et al., 2018; Dafermos et al., 2018; Svartzman, nificant challenges in managing large-scale insurance claims and oper­
Bolton, Despres, Pereira Da Silva, & Samama, 2021). However, there is ational risks (Ma & Song, 2023). Consequently, insurance companies
also a green finance gap, which is particularly pronounced in developing experience underwriting losses, resulting in a dilemma of revenue and
countries (Hafner, Jones, Anger-Kraavi, & Monasterolo, 2021; Hafner, expenditure imbalance. This dilemma, in turn, has ripple effects on
Jones, Anger-Kraavi, & Pohl, 2020). Therefore, central banks, financial critical operations like securities mortgage and credit financing, which
regulators, experts, and scholars are also considering new economic induces systemic financial risk. Moreover, the escalation in global
policies and tools at their disposal to further cope with the severe temperature and sea-level threatens public property and assets, influ­
challenges brought by climate change. Some scholars focus on monetary encing the structure and pricing of property insurance products (Massa
policy tools such as the use of “climate-enhanced” monetary policy & Zhang, 2021). Therefore, climate change-related direct losses and
(interest rate rules) decisions, and green quantitative easing (QE) to revaluation events can significantly impact financial stability.
improve financial distress caused by climate change (Chen, Pan, Huang, Credit risk channel. According to the modern risk management
& Bleischwitz, 2021; Dafermos et al., 2018; Schoenmaker, 2021). Other theory, credit risk stands as a primary risk confronted by banks. From
researchers focus on fiscal policy. For example, the carbon tax rate and the perspective of the corporate sector, climate disasters amplify the
adjustment of government expenditure are selected to weaken the likelihood of enterprises facing potential default risk, due to reductions
financial risk brought by climate change (Chan, 2020; Loganathan, in their liquidity and profitability. Hence, banking institutions might
Shahbaz, & Taha, 2014). In addition, Chenet et al. (2021) and D’Orazio tighten credit availability, dampening the vitality of the real economy
and Popoyan (2019) discuss the macroprudential policy of using capital and leading to an adverse impact on the financial sector (Noth &
and liquidity supervision to enhance the flexibility and toughness of Schüwer, 2023). From the perspective of residents, climate change can
financial institutions. disrupt the payment balance of bank debtors and erode their debt sol­
As far as this study is concerned, the existing literature focuses on the vency. Thus, a substantial number of loans may become non-performing,
negative impact of climate risk on financial stability. Despite the rapidly which heightens the credit risk of commercial banks and threatens their
growing literature on climate change and financial systems, they are financial stability (Dafermos et al., 2018).
limited to a country, a sector, or a specific financial asset (Painter, 2020; Operational risk channel. Human, physical, and natural capitals all
Schlenker & Taylor, 2021; Venturini, 2022). The problem of trans­ face vulnerability to the adverse consequences of climate change
national characteristics of the impact of climate risk on financial sta­ (Zheng, Pan, Xie, Zhou, & Liu, 2016). Climate disasters can damage the
bility still receives less attention, especially the impact of climate risk on infrastructure of financial institutions, resulting in casualties among
all sectors of the macroeconomy is fundamental. Climate risk can affect business personnel. This effect, in turn, can disrupt the continuity of
the financial stability of individual institutions or countries (Wu et al., financial institution operations, leading to operational disruptions and
2023). However, climate risk affects financial stability at the global level business interruptions (Wang & Wang, 2021).
due to the globalization of the economy and the interconnection of the Market risk channel. Based on the theory of uncertainty, losses
financial systems. Therefore, transnational evidence of climate risk caused by climate disasters possess a certain degree of randomness and
impacting financial stability needs to be provided. In addition, regula­ probability. As a result, accurately predicting the frequency and in­
tors and scholars also analyzed the effects of monetary, fiscal, and tensity of climate disasters becomes challenging. This challenge
macroprudential policies on policy measures to mitigate the impact of heightened financial instability and uncertainty in market operations
climate risk on the financial system (Baer, Campiglio, & Deyris, 2021). due to climate change, leading to price fluctuations in commodities,
However, most of the relevant papers are theoretical and few studies are company stocks, bonds, derivatives, and other financial instruments
empirical. Moreover, from the perspective of macroprudential policy (Cevik & Jalles, 2022; Fontana & Sawyer, 2016; Gallic & Vermandel,
structure, the existing literature ignores the effects of different macro­ 2020). Rising global temperatures and extreme weather events invari­
prudential tools. Finally, although climate risk affects all countries ably disrupt production processes and escalate procurement costs,
around the world, the extent of damage varies greatly from country to resulting in market volatility, indirect economic damage, and financial
country (Adom & Amoani, 2021). Some scholars concentrate on risks (Liu & He, 2016; Stern & Taylor, 2007). In the long run, rising sea
founding experience and propose that countries with more founding levels will increase the likelihood of flooding in coastal areas, leading to
experience have strong national capacity. These countries can adjust the inundation and disappearance of many coastal lands. Affected by
their climate policies through several institutional channels to cope with rising sea levels, the trading volume of the real estate market in coastal
climate risk shocks (Ang & Fredriksson, 2021). Then, as the direct areas may sharply decline, posing a risk of a sharp drop in housing
embodiment of the founding experience, the impact of national gover­ prices.
nance capacity on the relationship between climate change and financial Reputation and liability risk channel. On the one hand, the climate

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Fig. 1. The impact mechanism of climate risk on financial stability.

risks caused by extreme weather events are increasingly prominent, and macroprudential policies also set flexible regulatory requirements for
financial institutions should actively integrate ESG concepts into their financial institutions’ asset liquidity, financing leverage, liquidity, and
development strategies. Financial institutions with poor ESG perfor­ asset-liability composition, which avoids serious maturity mismatches
mance will face increasingly serious reputation and liability risks. On the and excessive market player debt (Mester, 2017). If climate risk nega­
other hand, with the escalation of climate change, financial institutions tively impacts the real economy, macroprudential policy weakens the
confront mounting pressure from institutional investors, shareholders, financial accelerator effect produced by the financial market, and avoids
regulatory bodies, and other stakeholders. If financial institutions fail to the vicious circle of repeated shocks between the real economy and
meet their obligations, and their business directly or indirectly increases financial market. Finally, the macroprudential policy increases the
carbon emissions, then, financial institutions not only face serious additional constraints on the cross-market financial products, leverage,
damage to their reputation and image, but also be punished by the law, and liquidity of systemically important financial institutions, and raises
causing business issues (Zobaa, 2005). the control requirements of financial holding companies in terms of
Liquidity risk channel. Climate change can devaluate loan collateral concentration and related party transactions (Kahou & Lehar, 2017).
held by financial institutions or cause lower-than-expected earnings These measures limit the scale of financial institutions’ high-risk busi­
from loan projects (Liu, Wang, & Li, 2021). As a result, financial in­ nesses and improves the quality of their assets and risk management
stitutions may be reluctant to lend, leading to insufficient liquidity in the ability (Altunbas, Binici, & Gambacorta, 2018). These effects weaken
market (Hosono et al., 2016). For businesses and residents, post-disaster the financial shock caused by the impact of climate risk on the real
reconstruction and production necessitate substantial financial re­ economy. Therefore, in the face of climate risk shocks, implementing
sources. Insufficient market liquidity exacerbates their financing con­ macroprudential policies maintain the financial system’s health and
straints, leading to a notable rise in the likelihood of default. Climate stability. Accordingly, this paper proposes hypothesis 2.
change-induced damage to individuals and property may elevate resi­
Hypothesis 2. Macroprudential policy can weaken the adverse impact
dents’ money demand due to heightened pessimistic expectations,
of climate risk on financial stability.
resulting in increased liquidity hoarding. Regarding the theory of bank
runs, this demand excess could raise the probability of banks facing National governance systems play a pivotal role in influencing
liquidity shocks and make them susceptible to situations such as runs various aspects, including political stability, administrative efficiency,
and money shortages, thereby endangering the stability of the financial supervision coverage, and government prestige. A well-functioning na­
system (Klomp, 2014). tional governance system fosters an institutional environment that is
In the context of climate physical risk impacting financial stability, conducive to promoting financial development (Emara & El Said, 2021;
the six transmission channels are not isolated or fixed entities. Instead, Jordaan, Dima, & Goleț, 2016; Omri, 2020). In addition, the more
they exhibit correlations and exert mutual influence on each other in a perfect the national governance system, the higher the controllable loan
dynamic evolution (Chenet et al., 2021). Furthermore, this interdepen­ rate, the lower the non-performing loan rate, and the stronger the
dence among the transmission channels may amplify the adverse nature financial stability (Wang, Lee, & Chen, 2022; Xv, 2018). Therefore,
of climate risks, resulting in significant systemic shocks to the financial when floods, droughts, and hurricanes caused by climate change impact
system. In light of this analysis, this paper posits the following the real economy in the short term, the financial system under the
hypotheses: perfect national governance system may have a strong resistance to
events such as default accidents and liquidity shocks. Also, the stable
Hypothesis 1. Climate risk has adverse shocks to financial stability.
national political situation and high administrative efficiency facilitate
When impacted by climate risk, macroprudential policies enhance the government to quickly carry out disaster relief operations. This
the robustness of financial institutions, and reduce the cross- facilitation also timely increases special transfer payments and public
institutional, − industry, and -market transmission of financial risk service expenditures, which directly or indirectly reduce casualties and
(Chenet et al., 2021). Firstly, macroprudential policies constrain the property losses caused by climate risk (Cisterna, Acuña-Duarte, & Sal­
asset composition of financial institutions by controlling the risk weight azar, 2022). Moreover, the national expectation will become relatively
of assets and increasing additional capital requirements. These measures stable with the efficient implementation of administrative measures to
prevent the problem of too single asset structure and concentrated risk reduce the interference of uncertainty in the financial system (Beshi &
exposures. A reasonable asset weight and risk structure can diversify the Kaur, 2020). Rising global temperatures and sea levels caused by climate
risk of assets depreciating sharply by climate risk shocks, and protect the change will hit the real economy in the long-run. Countries with com­
asset value of financial institutions to a certain extent. Secondly, plete governance systems can calm market sentiment and stabilize

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market interest rates and exchange rate fluctuations through adminis­ (Phan, Iyke, Sharma, & Affandi, 2021). Ratio of bank deposits to GDP
trative intervention. Moreover, it can also actively adjust the develop­ (Dep) measures the proportion of bank claims on domestic entity non-
ment strategy of the real economy and actively guide the affected actors financial sectors in GDP (Yin, 2019). The domestic credit of the pri­
to take adaptive measures, to reduce or even eliminate the long-term vate sector (Cre) is the financial resources provided to the private sector
impact of climate change on financial stability. Accordingly, this (Phan et al., 2021). Bank concentration (Con) measures the assets of the
paper proposes hypothesis 3. three largest banks in a country as a percentage of their total assets (Fu,
Lin, & Molyneux, 2014).
Hypothesis 3. The improvement of the quality of national governance
is conducive to mitigating the impact of climate risk on financial
4.4.2. Relevant macroeconomic control variables
stability.
GDP per capita (Gdpc) and its growth rate (Gdp) are the GDP per
capita and its change in percentage term (Fouejieu, 2017). Inflation rate
4. Model and variable
(Inf) is the changes in the consumer price index (Fouejieu, 2017).

4.1. Empirical model

4.5. Sample selection and data sources
Eq. (1) tests hypothesis 1 by assessing the impact of climate risk on
financial stability. This paper selected the sample countries based on several factors.
Firstly, from the perspective of geographical distribution, these coun­
Zscorei,t = α + β1 Crii,t + γControli,t + εi,t (1) tries are from various regions: Asia, Europe, Africa, Oceania, North
America, and South America. This wide geographical coverage ensures
where i represents country, t is year; Zscore denotes the financial sta­ the representation of a diverse range of countries and enhances the
bility, Cri is climate risk, Control shows some other control variables that universality of the findings. Secondly, the sample countries cover both
affect financial stability; and εi,t represents the random disturbance developed countries (e.g., the United States and the United Kingdom) as
term. well as developing and emerging economies (e.g., China and India). This
sampling ensures a certain degree of comprehensiveness in representing
4.2. Explained variables economies at various stages of development. Thirdly, concerning the
severity of the impact of climate change, the sample includes countries
According to Creel, Hubert, and Labondance (2015) and Fazio, Silva, such as Haiti, the Philippines, and other island nations with unique
Tabak, and Cajueiro (2018), this paper uses the national level of Zscore geographical locations and experiencing significant climate impacts,
to measure financial stability. The following equation calculates the thus providing a robust representation. Finally, due to constraints
probability of bank bankruptcy. related to data availability and completeness, this paper selects panel
data from 53 countries from 2007 to 2019. Table 1 shows the specific
Roa + Equity
Zscore = Assets
(2) sample countries selected in this paper.
σRoa
The climate risk data comes from the Global Climate Risk Index
where Roa is the rate of return on bank assets, σ Roa represents the published by Germanywatch. In addition, this paper collates data on
standard deviation of the bank’s return on assets, Equity shows the financial stability and bank-related variables from the World Bank’s
bank’s share capital, and Assets denotes the bank’s total assets. Higher Global Financial Development Databases. The relevant macroeconomic
Zscore values indicate stronger stability, also known as lower bankruptcy data is obtained from the World Bank’s World Development Indicators.
risk. Table 2 shows the descriptive statistics of the main variables.

5. Analysis of empirical results

4.3. Core explanatory variables

5.1. Benchmark regression results

This paper uses the Global Climate Risk Index (Cri) constructed by
The Germanwatch to measure the climate risk of each country. The
Table 3 reports the estimated results using different combinations of
Climate Risk Index is based on the objective and detailed NatCatSER­
control variables. In addition, considering the consistency of estimators,
VICE database for analysis. This index covers the adverse impact of
this paper takes the more robust fixed effect estimation results as the
various weather events on most countries as much as possible, such as
benchmark. The random effect estimation results are also attached.
direct losses and deaths. It not only studies the absolute loss index (total
Specifically, columns 1 and 2 do not add any control variables, columns
disaster deaths and losses), but also supplements the relative loss index
3 and 4 add bank-related control variables, and columns 5 and 6 further
(deaths per 100,000 residents and losses per unit of GDP). This helps to
objectively analyze the impact of climate events according to the actual
situation and specific capabilities of each country. In addition, Cri also Table 1
Sample countries.
gives the respective weights of the four indicators in the calculation, and
gives the climate risk index scores of each country according to the Developed country Developing and emerging economy
average ranking among the four indicators. The lower the index score, Australia Algeria Ghana Namibia
the higher the ranking. This means that the host country is at risk of Canada Bangladesh Guatemala Nicaragua
being hit by frequent weather events or rare but devastating weather France Brazil Haiti Nigeria
Germany Burkina Faso Honduras Pakistan
disasters. To more intuitively understand the logical relationship among
Italy Cameroon India Paraguay
observation data, this paper negatively processes the climate risk index Japan Chile Indonesia Peru
scores of various countries. Multiplying all the scores by - 1, the higher Netherlands China Jamaica Philippines
the climate risk index score, the greater the climate risk of the country. Norway Colombia Kenya Poland
Spain Costa Rica Laos PDR Portugal
Switzerland Ecuador Madagascar Russian Federation
4.4. Control variables United Kingdom Fiji Mexico Senegal
United States Georgia Mozambique Sri Lanka
4.4.1. Bank-related control variables Sudan Thailand Uganda
Ukraine Zambia
Bank Return on Assets (Roa) is the ratio of net profit to total assets

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Table 2 “lead one hair and affect the whole body”. Once a financial problem
Descriptive statistics of the main variables. occurs, its risk effect quickly spreads to other financial institutions, thus
Variable Obs. Mean Standard Min Max increasing the instability of the financial system (Jiang, Cai, & Li, 2019;
deviation Liu, Yu, Yang, & Zhu, 2017). The estimated coefficient of the ratio of
Zscore 658 15.3815 7.2247 2.6904 38.6281 bank deposits to GDP is not significant. Creditor’s rights in non-financial
Cri 685 − 55.9018 27.7569 − 126.1700 − 2.1700 sectors can increase financial risk by expanding credit demand, and can
Con 658 62.1607 18.6462 22.3073 100.0000 also enhance financial stability by promoting economic development
Roa 652 1.2186 1.7791 − 23.8873 6.0908 (Beck & Demirguc-Kunt, 2009; Fouejieu, 2017). Therefore, the ratio of
Dep 666 66.6489 46.7675 8.3263 196.5384
Cre 647 62.1431 49.6357 6.5433 206.3510
bank deposits to GDP does not have a significant impact on financial
Gdp 689 3.3276 3.2121 − 17.0047 14.2309 stability. The estimated coefficient of GDP is significantly negative.
Inf 689 5.1705 5.8727 − 3.2334 63.2925 Some countries have a system of fiscal decentralization and political
Gdpc 689 14,189.8665 20,003.6053 436.6838 87,123.6604 centralization. In this case, local governments may intervene excessively
in the financial market in pursuit of the goal of one-sided GDP growth.
This leads to the low efficiency of capital allocation in the financial
add macro-level control variables. According to Table 3, the estimation
system and cannot maintain the development and stability of the
coefficient of climate risk is significantly negative irrespective of fixed or
financial system. The inflation rate is negatively correlated with finan­
random effect estimations. This result confirms the adverse effects of
cial stability. Inflation leads to a decline in the purchasing power of
climate risk on financial stability, supporting hypothesis 1.
money and fluctuations in asset prices, affecting financial stability.
Some useful conclusions can also be drawn from the estimated re­
sults of control variables. The return on bank assets is significantly and
positively correlated with financial stability. The higher the rate of re­ 5.2. Robustness test
turn on assets, the stronger the survival and development ability of
banks, which alleviates sudden external shocks and help maintain the The replacing explained variable, changing estimation methods, and
stable operation of the financial system (Lin & Yang, 2016). In addition, time robustness test are used to ensure the reliability of research con­
the estimated coefficient of GDP per capita is significantly positive. The clusions. The robustness test results are shown in Table 4.
increase in per capita GDP promotes financial stability. When a coun­ The first technique is the replacement of explained variable.
try’s per capita income level increases, citizens’ solvency and savings Considering the bias and heteroscedasticity of Zscore, a measure of bank
capacity improve accordingly. This not only reduces credit risk, but also risk, may interfere with the empirical results (Guo, Cheng, & Shen,
enables financial institutions to have stable and continuous financing 2021). Therefore, this paper takes the logarithm of Zscore and re-
channels, thus improving the stability of the financial system (Han & estimates Eq. (1). Columns 1 and 2 of Table 4 show the results.
Melecky, 2017). However, the estimated coefficient of private-sector Although the magnitude of the climate risk estimation coefficient is
domestic credit is significantly negative, indicating the negative effect slightly different, the coefficient symbol and significance are consistent
of private-sector domestic credit on financial stability. The private sector with our results. In other words, regardless of the fixed or random effects
is characterized by a smaller scale and greater risk. Due to the existence models, the estimation coefficient of climate risk is still significantly
of information asymmetry, financial institutions hardly assess and su­ negative, indicating that the previous estimation results have good
pervise the solvency and loan behavior of the private sector. Therefore, robustness.
the more domestic credit available to the private sector, the more po­ The second approach is the change in the estimation method.
tential risk to the financial system. Bank concentration has a negative Financial stability and bank-related variables may be mutually causal
correlation with financial stability. Excessive bank concentration in­ endogenous problems. Therefore, this paper uses the lag first order of
creases monopoly power and raises the cost of financing for individuals bank-related variables as instrumental variables, and adds the lag first
and enterprises, which increases the potential default rate of lenders and order of financial stability. The difference generalized moment estima­
affects financial stability. Also, the excessive concentration of banks tion method (DIF-GMM) is used to re-estimate Eq. (1) to solve the po­
leads to the situation that banking institutions are “too big to fail” and tential endogeneity problems in the regression model. Column 3 of
Table 4 shows the estimated results. According to the regression results,

Table 3
Results of the effect of climate risk on financial stability.
Variable (1) (2) (3) (4) (5) (6)

FE RE FE RE FE RE

Cri − 0.0108*** − 0.0100** − 0.0115*** − 0.0106*** − 0.0098*** − 0.0101***

(0.0039) (0.0039) (0.0039) (0.0039) (0.0036) (0.0038)
Roa 0.4183*** 0.4179*** 0.3990*** 0.4192***
(0.0713) (0.0715) (0.0667) (0.0701)
Dep − 0.0117 − 0.0212 0.0051 − 0.0164
(0.0191) (0.0179) (0.0179) (0.0177)
Cre − 0.0226 − 0.0067 − 0.0497*** − 0.0295
(0.0203) (0.0187) (0.0190) (0.0188)
Con − 0.0338*** − 0.0342*** − 0.0154* − 0.0288***
(0.0096) (0.0095) (0.0091) (0.0093)
Gdp − 0.0737** − 0.0615*
(0.0345) (0.0362)
Gdpc 0.0009*** 0.0003***
(0.0001) (0.0000)
Inf − 0.0509** − 0.0563**
(0.0248) (0.0261)
Constant 14.7868*** 15.1168*** 18.5727*** 18.6323*** 6.5212*** 16.1520***
(0.2348) (0.9843) (0.8871) (1.3156) (1.5730) (1.4940)
R2 0.0124 0.1157 0.2557

Notes: Significance levels: *** (1%), ** (5%), * (10%); Standard errors are shown in parentheses.

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Z. Liu et al. International Review of Financial Analysis 92 (2024) 103096

Table 4
Results of the robustness test.
Variable lnZscore lnZscore Zscore Zscore Zscore

FE RE Difference GMM 2007–2014 2010–2014

Cri − 0.0007*** − 0.0007** − 0.0065** − 0.0111** − 0.0062*

(0.0003) (0.0003) (0.0033) (0.0045) (0.0037)
Roa 0.0424*** 0.0439*** 0.2519*** 1.1090*** 1.0674***
(0.0050) (0.0052) (0.0812) (0.1365) (0.1175)
Dep − 0.0003 − 0.0014 0.1410*** − 0.0131 − 0.0970**
(0.0013) (0.0013) (0.0291) (0.0284) (0.0418)
Cre − 0.0032** − 0.0022 − 0.2183*** − 0.0155 0.0368
(0.0014) (0.0014) (0.0383) (0.0287) (0.0401)
Con − 0.0020*** − 0.0029*** − 0.0685*** − 0.0126 − 0.0347***
(0.0007) (0.0007) (0.0163) (0.0120) (0.0108)
Gdp − 0.0027 − 0.0018 − 0.0180 − 0.0727* − 0.0748*
(0.0026) (0.0027) (0.0310) (0.0394) (0.0414)
Gdpc 0.0001*** 0.0000*** 0.0006*** 0.0004** 0.0003
(0.0000) (0.0000) (0.0001) (0.0002) (0.0002)
Inf − 0.0043** − 0.0047** − 0.0779*** − 0.0487 − 0.1231***
(0.0019) (0.0019) (0.0222) (0.0328) (0.0386)
[Link] 0.1494*
(0.0772)
Constant 2.0833*** 2.7307*** 12.8645*** 10.7166*** 16.4194***
(0.1176) (0.1035) (2.4093) (2.6998) (3.3234)
2
R 0.2998 0.2416 0.4227
AR(1) P value 0.0013
AR(2) P value 0.1321
Sargan P value 1.0000

Notes: Significance levels: *** (1%), ** (5%), * (10%); Standard errors are shown in parentheses.

climate risk significantly and negatively correlates with financial sta­ 5.3. Heterogeneity analysis
bility after controlling for endogenous factors. This result confirms our
findings. To explore whether climate risk has different impacts on financial
Third, a time robustness test examines the relationship between stability in various countries in a more detailed way, this paper divides
climate risks and financial stability. Nonetheless, the robustness test the samples into three groups, and the test results are shown in Table 5.
excludes certain events that may affect the results, ensuring the validity
of the results. Notably, the Paris Agreement, recognized as an interna­ 5.3.1. Heterogeneity of economic development level
tional milestone in addressing the climate challenge, could have Due to the different levels of economic development in various
fundamental impacts (Böhringer, Peterson, Rutherford, Schneider, & countries, the resilience of the real economy to climate risk varies
Winkler, 2021). To mitigate the influence, the regression re-estimates greatly. Developed countries have already incorporated climate plan­
the coefficients and statistics after removing data between 2015 and ning and response measures into their development strategies. Countries
2019. This estimation repeats the filtering for the period between 2007 with relatively backward economic development may have less
and 2009 for the impact of the global financial crisis on financial sta­ consideration of climate change due to excessive pursuit of GDP growth
bility. The estimated results are shown in columns (4) and (5) of Table 4. (Sarkodie & Strezov, 2019). The impact of climate risk on financial
The estimated coefficients of climate risk are significantly negative, stability may depend on the degree of economic development in a
indicating that the results of this paper are robust. country. Therefore, after the impact of climate risk, countries with
different levels of economic development may also have different levels

Table 5
Results of the heterogeneity analysis.
Variable Developed Developing and emerging Financially developed Financially restricted High competition Low competition

Cri 0.0029 − 0.0087** − 0.0056 − 0.0083** − 0.0147*** 0.0020

(0.0102) (0.0036) (0.0069) (0.0040) (0.0052) (0.0040)
Roa 2.6194*** 0.3396*** 1.9555*** 0.3172*** 0.3066*** 1.2197***
(0.3954) (0.0638) (0.2631) (0.0659) (0.0803) (0.1324)
Dep 0.0005 0.0268 − 0.0038 0.0581** − 0.0145 0.0151
(0.0267) (0.0242) (0.0215) (0.0291) (0.0297) (0.0165)
Cre − 0.0501* − 0.0466* − 0.0456** − 0.0494 − 0.0338 − 0.0592***
(0.0275) (0.0251) (0.0221) (0.0323) (0.0315) (0.0176)
Con − 0.1552*** − 0.0084 − 0.0424*** − 0.0053 − 0.0048 − 0.0421***
(0.0387) (0.0091) (0.0151) (0.0105) (0.0117) (0.0137)
Gdp − 0.0171 − 0.0660* − 0.0220 − 0.0630* − 0.0841* − 0.0181
(0.0995) (0.0350) (0.0748) (0.0371) (0.0473) (0.0421)
Gdpc 0.0007*** 0.0007*** 0.0007*** 0.0001 0.0011*** 0.0005***
(0.0001) (0.0002) (0.0001) (0.0002) (0.0001) (0.0001)
Inf − 0.5964*** − 0.0368 − 0.4759*** − 0.0392 − 0.0330 − 0.0778***
(0.1681) (0.0240) (0.1104) (0.0249) (0.0358) (0.0270)
Constant 1.3894 12.9903*** − 2.7217 14.1894*** 2.5130 12.7306***
(6.2222) (1.0868) (3.9342) (1.1684) (2.4111) (1.5898)
R2 0.6544 0.1384 0.6022 0.1023 0.2733 0.4272

Notes: Significance levels: *** (1%), ** (5%), * (10%); Standard errors are shown in parentheses.

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Z. Liu et al. International Review of Financial Analysis 92 (2024) 103096

of financial system response. In this regard, this paper divides the low degree of competition. According to the competition-fragility the­
samples into developed, developing, and emerging economies according ory, in countries with a high degree of competition in the financial
to the classification of IMF. Columns 1 and 2 of Table 5 show the results system, fierce market competition weakens the bargaining space and
of the group test. monopoly ability of financial institutions in the financing market. This
The estimated coefficient of Cri is significant and negative in devel­ effect reduces industry profit margins and directly weakens the viability
oping countries and emerging economies, while the estimated coeffi­ of financial institutions in the face of external shocks (Elfeituri, 2022). In
cient of cri is insignificant in developed countries. This result shows that addition, the profit motivation drives financial institutions to lower their
climate risk mainly affects the financial stability of developing and lending standards and to lend and invest in high-risk assets. Therefore,
emerging economies, while the impact on financial stability is insignif­ financial competition makes financial institutions more vulnerable to
icant in developed countries. Developed countries have a good economic the negative effects of real economic losses and uncertainties caused by
operation model and a large amount of investment in prevention, which climate risk, threatening the stability of the financial system (Guidi,
can cushion the impact of climate risk on the real economy. In addition, 2021).
a sound emergency management system and sufficient physical capital
stock can also reduce the financial impact caused by the turmoil of the
real economy. Developing and emerging economies not only lack the 5.4. Further analysis
awareness and ability to prevent disasters, but also have relatively weak
industrial systems and poor ability to resist risk (Song, Wang, & Wang, 5.4.1. Macroprudential policy moderating mechanism
2023). This result aggravates the impact of climate risk on the real This study formulates the following model to investigate the impact
economy, and then shakes the normal operation of the financial system. of macroprudential policies on the relationship between climate risk and
financial stability.
5.3.2. Heterogeneity of financial development level Zscorei,t = α + β1 Crii,t *mpi high + β2 Crii,t *mpi low + γControli,t + εi,t (3)
The financial sector may respond differently to climate risk because
of the different developments in the financial sector across countries. where i represents country, t is year, Zscore denotes financial stability,
Therefore, based on the ratio of private sector credit to GDP, this paper Cri is climate risk, εi,t represents the random disturbance term, and
sets the countries with a ratio greater than the mean as financially Control is defined previously.
developed countries, and the countries with a ratio less than the median This paper collects 16 different types of macroprudential policy tools
as financially restricted countries. Columns 3 and 4 of Table 5 show the from 53 countries, and then aggregates them to construct macro­
results of the group test. prudential policy indicators. The data comes from the integrated Mac­
The estimated coefficient of Cri is significantly negative in the group roprudential Policy (iMaPP) database. Subsequently, we create two
of financially restricted countries, but insignificant in the group of dummy variables mpi_high and mpi_low according to Phan et al. (2021).
financially developed countries. These results suggest that climate risk The values of mpi_high and mpi_low are 1 when the number of macro­
threatens the financial stability of financially constrained countries, prudential policies adopted by a country is higher and lower than the
while climate risk has an insignificant impact on the financial stability of sample average, respectively; otherwise, they are 0. The estimated re­
financially developed countries. Financially developed countries have a sults are shown in Table 6. According to column 1 of Table 6, the more
high quality of financial development and relatively perfect financial macroprudential policies adopted by countries, the more beneficial it
operation system. Therefore, when climate risk occurs, financially will be to reduce the negative impact of climate risk on financial sta­
developed countries not only have more opportunities to diversify or bility. Thus, hypothesis 2 is verified.
transfer risk, but also have strong financial adjustment capabilities (Mao Various macroprudential tools have various application directions
& Zhang, 2020). However, the financial system of financially restricted and effects, leading to different estimation results. For conducting
countries is often stunted and more vulnerable to external shocks (He, further tests, this study divides the collected macroprudential tools into
Miao, Yan, & Shen, 2021). Thus, when exposed to climate risk, financial
systems in financially restricted countries can be destabilized. Table 6
Effect of the macroprudential policy on climate risk and financial stability
5.3.3. Heterogeneity of competition level relationship.
Considering the heterogeneity in the degree of competition among Variable Macroprudential Asset- Buffer Borrower
countries may have a differential impact on financial stability, leading to policy liability
different regression results. We also divide the sample into two sub-
Cri*mpi_high − 0.0064 − 0.0020 − 0.0028 − 0.0102*
samples of countries with high levels of financial competition and (0.0062) (0.0058) (0.0064) (0.0055)
countries with low levels of financial competition. Currently, scholars Cri*mpi_low − 0.0115*** − 0.0147*** − 0.0129*** − 0.0074
mostly use H-statistics, Boone index, Concentration index, and Lerner (0.0044) (0.0046) (0.0043) (0.0045)
Roa 0.4011*** 0.3959*** 0.4028*** 0.3991***
index to measure banking market competition. The basic idea behind the
(0.0668) (0.0666) (0.0667) (0.0643)
Boone indicator is that efficient firms are more rewarded in more Dep 0.0052 0.0041 0.0053 0.0046
competitive markets. However, efficient gains may not be translated (0.0179) (0.0179) (0.0179) (0.0174)
into higher profits in the short-term, which may affect the accuracy of Cre − 0.0498*** − 0.0486** − 0.0499*** − 0.0493***
the Boone index (Leon, 2015). The Concentration index has defects in (0.0190) (0.0190) (0.0190) (0.0184)
Con − 0.0156* − 0.0162* − 0.0156* − 0.0205**
theory, and the Lerner index fails to fully consider the degree of product
(0.0091) (0.0091) (0.0091) (0.0088)
substitution in the market (Shen & Zhao, 2017). This paper collects the Gdp − 0.0748** − 0.0774** − 0.0758** − 0.0660*
H-statistic as a proxy variable of the degree of competition in the (0.0346) (0.0345) (0.0345) (0.0345)
financial system from the World Bank’s global financial development Gdpc 0.0009*** 0.0009*** 0.0009*** 0.0008***
database. Take it as the basis for dividing the degree of national financial (0.0001) (0.0001) (0.0001) (0.0001)
Inf − 0.0503** − 0.0486* − 0.0499** − 0.0543**
competition. According to the mean of H-statistic, we divide the in­ (0.0249) (0.0248) (0.0248) (0.0245)
dividuals into above and below the median, representing countries with Constant 6.4583*** 6.4045*** 6.4053*** 6.8091***
high and low competition, respectively. The estimated results are shown (1.5766) (1.5716) (1.5746) (1.5245)
in columns 5 and 6 of Table 5. R2 0.2563 0.2598 0.2580 0.2749
The estimated coefficient of Cri is significantly negative in countries Notes: Significance levels: *** (1%), ** (5%), * (10%); Standard errors are
with a high degree of competition, but insignificant in countries with a shown in parentheses.

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Z. Liu et al. International Review of Financial Analysis 92 (2024) 103096

three categories, namely asset-liability, buffer, and borrower macro­ This study evaluates the quality of national governance systems in
prudential tools. Columns 2 to 4 in Table 6 show that various types of the sample countries according to the world governance indicator (WGI)
macroprudential tools have different effects. constructed by the world bank in 1996. This index consists of six di­
Specifically, asset-liability macroprudential instruments are effective mensions: political stability, government efficiency, corruption control,
in mitigating financial instability caused by climate risk. In climate risk, voice and accountability, supervision level, and legal system. The data
asset liability instruments directly limit the financial institutions’ high- comes from the WDI database in the World Bank. The higher the na­
risk business by strengthening the supervision of risk exposure, liquidity, tional governance index, the higher the quality of national governance.
and leverage level (Altunbas et al., 2018). This regulates the asset lia­ In other words, when a country’s national governance index is higher
bility structure, improving the asset quality and risk control level of (lower) than the average level of all countries in the sample, the coun­
financial institutions and strengthening financial stability. Also, asset try’s governance level is high (low). According to Phan et al. (2021), we
liability instruments strengthen the restrictions on interbank risk, create two virtual variables wgi_high and wgi_low. The values of wgi_­
restrict the scale of interbank business among financial institutions, and high and wgi_low are 1 when a country has a high and low level of
reduce the possibility of mutual transmission of financial risk among governance, respectively; otherwise, they are 0. Table 7 shows the
financial institutions due to financial interconnection (Ćehajić & Košak, estimated results.
2021). Therefore, asset liability macroprudential instruments mitigate Column 1 of Table 7 reports the estimated results of the national
the financial fluctuations caused by climate risk. governance index. According to Table 7, climate risk has an insignificant
Consistent with asset-liability macroprudential instruments, buffer effect on financial stability in countries with high governance quality. If
macroprudential instruments can also reduce climate financial risk. the national governance has poor quality, financial stability is vulner­
Buffer macroprudential instruments adjust the size of loss provisions by able to climate risk, accepting hypothesis 3.
imposing additional capital requirements on financial institutions This paper adopts the sub-index of corruption control to investigate
(Mester, 2017). When climate risk negatively affects financial in­ whether the use of public power by governments and whether the pre­
stitutions, sufficient loss reserve capital deals with the uncertainty vention and supervision of corruption affect the impact of climate risk
caused by climate risk at any time, and offsets the asset loss caused by on financial stability. Column 2 of Table 7 represents the estimated re­
climate risk events in time, to smooth financial fluctuations. In addition, sults. Consistent with the estimated overall index of national gover­
buffer-type macroprudential tools also conduct counter-cyclical adjust­ nance, the impact of climate risk on financial stability is insignificant in
ments to financial institutions to limit excessive contraction and countries with strong corruption control. The financial stability of
expansion of credit (Altunbas et al., 2018). This adjustment reduces the countries with poor corruption control is more affected by climate risk.
risk accumulation caused by the excessive expansion of credit business, When climate change occurs, a clean and honest national government
avoids the systemic financial crisis caused by the sudden impact of can efficiently use social resources to carry out disaster relief campaigns.
climate events, enables financial institutions to maintain a stable credit This approach can quickly restore the normal operation of the real
supply after the impact of climate risk, and prevents the economic economy and stabilize the financial system, but countries with weak
recession caused by excessive credit contraction. Thus, buffer macro­ corruption controls can breed corruption. In this case, public power can
prudential tools mitigate financial instability caused by climate risk. easily abuse their own private interests, leading to the loss and waste of
Unlike the asset liability and buffer macroprudential instruments, disaster relief resources, delaying economic recovery, and triggering
the more macroprudential instruments imposed on borrowers, the more financial turmoil (Zafar, Rahman, & Ammara, 2023). In addition, the
the impact of climate risk on financial stability. The borrower facility corrupt bureaucratic environment also seriously damaged the authority
reduces the demand for loans and the ability to borrow by limiting the of the government, and restricted the implementation of policies and the
incentives and leverage levels of the national debt. In case of climate operation of laws (Zhang et al., 2019). Finally, the economic investment
risk, borrower tools reduce the social effective credit demand and credit environment deteriorated, the pessimistic expectation became more and
business scale. The depression of the credit business enhances the degree more serious, and the financial stability is destroyed.
of loan competition in the financial industry, and then squeezes the The quality of public service depends on the administrative inter­
financial institutions’ loan pricing power and profit space, affecting vention, policy planning, and implementation of each government,
their risk-taking ability. Moreover, loan competition will force financial which are artificially different in various countries. This paper in­
institutions to hedge the decline of interest rate spread income by vestigates the effect of these factors on the quality of public service using
increasing the scale of risk asset allocation (Fu et al., 2014). This effect the government efficiency sub-index. Column 3 of Table 7 represents the
aggravates the financial institutions’ vulnerability and threatens finan­ estimated results. According to column 3 of Table 7, climate risk is
cial stability. From the debtor’s viewpoint, the borrower’s macro­ ineffective in financial stability in countries with efficient governments.
prudential tools exacerbate the borrower’s capital dilemma, improve the However, climate risk significantly weakens the financial stability in
risk of breaking the enterprise’s capital chain, and increase the proba­ countries with less efficient governments. Countries with efficient gov­
bility of bankruptcy. The shortage of residents’ funds has declined the ernments can quickly coordinate monetary and macroprudential pol­
consumption capacity and the gradual shrinkage of social production icies to reduce climate risk. Accurate and effective policy tools reduce
(Kim & Mehrotra, 2022). These cases magnify the damage of climate risk the disruption of uncertainty and real economic losses to the financial
to the real economy, and then increase economic volatility, which system. However, countries with low government efficiency often cause
threatens financial stability. Therefore, the borrower’s macroprudential policy distortion due to long policy-making time lag and poor admin­
instruments boost the impact of climate risk on financial stability. istrative implementation effectiveness after climate risk impact, leading
to the complete or partial failure of the original policy function. The real
5.4.2. National governance quality moderating mechanism economy and the financial system are not only unable to recover quickly
This study constructs the following model to examine the impact of and effectively, but also they may even fall into a more chaotic situation.
national governance quality on the relationship between climate risk Column 4 of Table 7 shows the estimated results of the political
and financial stability. stability sub-index. Although climate risk significantly undermines the
financial stability of countries with poor political stability, it has an
Zscorei,t = α + β1 Crii,t *wgi high + β2 Crii,t *wgi low + γControli,t + εi,t (4)
insignificant effect on the financial stability of countries with strong
political stability. When climate risk occurs, politically stable countries
where i represents country, t is year, Zscore is financial stability, and Cri
can stabilize national expectations, market interest rates, and exchange
is climate risk, εi,t represents the random disturbance term, and Control is
rate fluctuations to calm financial shocks through continuous, stable,
defined previously.
and sustainable administrative regulation. In countries with chaotic

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Z. Liu et al. International Review of Financial Analysis 92 (2024) 103096

Table 7
Effect of the quality of national governance on climate risk and financial stability relationship.
Variable National governance index Corruption Government efficiency Political stability Supervision Legal Discourse power and accountability

Cri*wgi_high − 0.0087 − 0.0062 − 0.0093 − 0.0073 − 0.0094 − 0.0062 − 0.0092

(0.0059) (0.0066) (0.0059) (0.0053) (0.0061) (0.0063) (0.0057)
Cri*wgi_low − 0.0104** − 0.0113*** − 0.0100** − 0.0120** − 0.0100** − 0.0115*** − 0.0101**
(0.0045) (0.0043) (0.0045) (0.0049) (0.0045) (0.0044) (0.0047)
Roa 0.3995*** 0.4012*** 0.3991*** 0.3999*** 0.3991*** 0.4024*** 0.3993***
(0.0668) (0.0668) (0.0667) (0.0667) (0.0667) (0.0669) (0.0668)
Dep 0.0048 0.0050 0.0050 0.0044 0.0050 0.0050 0.0050
(0.0180) (0.0179) (0.0180) (0.0180) (0.0180) (0.0179) (0.0180)
Cre − 0.0495*** − 0.0497*** − 0.0496*** − 0.0492** − 0.0496*** − 0.0497*** − 0.0496***
(0.0191) (0.0190) (0.0190) (0.0190) (0.0191) (0.0190) (0.0190)
Con − 0.0154* − 0.0151* − 0.0154* − 0.0152* − 0.0154* − 0.0151* − 0.0154*
(0.0091) (0.0091) (0.0091) (0.0091) (0.0091) (0.0091) (0.0091)
Gdp − 0.0736** − 0.0740** − 0.0736** − 0.0733** − 0.0737** − 0.0738** − 0.0737**
(0.0345) (0.0345) (0.0345) (0.0345) (0.0345) (0.0345) (0.0345)
Gdpc 0.0009*** 0.0009*** 0.0009*** 0.0009*** 0.0009*** 0.0009*** 0.0009***
(0.0001) (0.0001) (0.0001) (0.0001) (0.0001) (0.0001) (0.0001)
Inf − 0.0512** − 0.0507** − 0.0510** − 0.0515** − 0.0510** − 0.0505** − 0.0510**
(0.0249) (0.0249) (0.0249) (0.0249) (0.0249) (0.0249) (0.0249)
Constant 6.5231*** 6.4814*** 6.5169*** 6.5194*** 6.5213*** 6.4840*** 6.5226***
(1.5745) (1.5751) (1.5751) (1.5739) (1.5745) (1.5748) (1.5745)
R2 0.2557 0.2562 0.2557 0.2563 0.2557 0.2563 0.2557

Notes: Significance levels: *** (1%), ** (5%), * (10%); Standard errors are shown in parentheses.

political status, vicious events occur from time to time, such as repeated among countries may influence the regression results. This paper further
policies and social riots, due to the lack of extensive political influence uses the index of discourse power and accountability system. Column 7
and strong government prestige (Elfeituri, 2022). These countries can of Table 7 shows the estimated results. Similarly, countries with sound
neither effectively guide the affected subjects to take adaptive measures, voice and accountability systems can maintain their financial stability
nor timely use macro-control to restore the real economy. Therefore, under the impact of climate risk. In contrast, countries without voice and
countries with political instability are prone to financial risk after accountability systems cannot. When climate risk occurs, sufficient
suffering from climate risk. voice can unblock information channels and effectively eliminate in­
This paper uses the sub-index of supervision level to test whether formation asymmetry, which stabilizes market sentiment and eases
different levels of supervision affect the results. Column 5 of Table 7 financial volatility. Moreover, a perfect accountability system can
offers the estimated results. For countries with complete regulation, strengthen the administrative order and reduce the dereliction of duty
climate risk will not cause financial instability. However, financial sta­ and malfeasance. In this way, this system boosts the rapid recovery of
bility is vulnerable to climate risk in countries with weak regulation. economic activities and social order, and generates positive expectations
Countries with high supervision levels have a good market supervision to stabilize the financial system (Yan, Wu, Wang, & Wu, 2021).
ability and can strictly control the non-performing loan ratio, capital
adequacy ratio, and operating procedures of financial institutions 6. Conclusion
(Noman, Gee, & Isa, 2018). This control improves the robustness of the
financial system in the face of climate risk. In countries with poor su­ As one of the most urgent issues today, the financial risk caused by
pervision, financial institutions not only have low financial transparency climate change has aroused extensive discussion among scholars. This
and operation efficiency, but also often lack good risk management paper empirically tests the relationship between climate risk and
awareness and poor ability to prevent and resist risk (González, 2009). financial stability, and draws the following conclusions, using the panel
Therefore, countries with weak supervision are often unable to maintain data of 53 countries from 2007 to 2019. First, climate risk damages
normal financial order in the face of sudden climate risk shocks. financial stability, which is different in various countries. Specifically,
Considering the obvious differences in the legal system and law climate risk threatens the financial stability only in developing and
enforcement capacity of different countries, this paper further studies it emerging economies, despite its insignificant effect on the financial
according to the legal sub-index. Column 6 of Table 7 represents the stability in developed countries. In addition, when facing climate risks,
estimated results. When countries with sound legal systems are exposed financial system turbulence is more pronounced in countries with
to climate risk shocks, their financial systems are less volatile. However, limited financial development or greater financial competition. Second,
climate risk shocks damage the financial system of countries without a macroprudential policies are effective in maintaining financial stability
perfect legal system since a perfect legal system helps all actors form in countries exposed to climate risk. In addition, the different types of
stable expectations for future economic activities in the case of climate macroprudential instruments play a significantly different role in miti­
risk. As a result, uncertainties in production and transactions in the real gating financial instability caused by climate risk. These differences are
economy will be reduced, effectively mitigating financial fluctuations reflected in the fact that asset liability and buffer macroprudential in­
caused by the impact of climate risk on the real economy. In addition, struments are effective in calming the financial fluctuations caused by
countries with perfect legal systems usually have strong contract climate risk, while the macroprudential policies imposed on borrowers
execution quality and contract enforcement, which reduce the credit risk boost the negative impact of climate risk on financial stability. Third,
faced by financial institutions when they are exposed to climate risk, and improving the quality of national governance can mitigate the adverse
help maintain financial stability (Zhu, Peng, & Zhang, 2020). Countries impact of climate risk on financial stability. Many factors maintain
lacking the rule of law usually have weak awareness of rules and higher financial stability after suffering from climate risk: enhancing national
moral hazards, leading to inefficient capital markets and fragile finan­ stability, improving government efficiency, supervision and legal sys­
cial systems. As a result, climate risk adversely affects the financial tem, strictly controlling corruption, and improving the right to speak
systems of countries without the rule of law. and accountability.
Finally, the heterogeneous degrees of freedom and democracy The conclusion of this paper offers substantial transnational evidence

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Z. Liu et al. International Review of Financial Analysis 92 (2024) 103096

that contributes to a comprehensive understanding of climate financial perspective of the policy mix, future research can simulate the combined
risks. Moreover, it provides valuable insights into the effective preven­ effects of different macro-policy combinations to determine the optimal
tion and control of such risks. These contributions are primarily re­ policy mix for addressing climate risks.
flected in the following aspects:
First, governments worldwide should enhance climate risk response Funding
and management capabilities including enhancement of capacity for
monitoring climate change, effective management of climate financial This work was supported by National Natural Science Foundation of
risks, and regularly assessing the effectiveness of climate change-related China (71903114); Youth Innovation Technology Project of Higher
policies. National financial institutions should prioritize the identifica­ School in Shandong Province (2022RW049).
tion of climate financial risk transmission paths and conduct targeted
climate risk stress tests to enhance their identification and management Data availability
capacity of climate financial risks. In addition, all financial institutions
should consider the major actions and progress of their peers in Data will be made available on request.
addressing climate risks. This mutual consideration fosters cooperation
and knowledge sharing in mitigating climate-related risks within the References
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