The impact of climate change on credit portfolios and banking resilience: Preliminary evidence from a developing economy

Abstract

This study investigates the impact of climate change on credit portfolios and banking resilience in Pakistan, a developing economy with significant exposure to environmental risks. We employ a stress-testing methodology to evaluate the effects of various climate change scenarios on banking firms, ranging from low to high emissions. Specifically, using data from 2011 to 2022, we assess the credit exposure of key sectors by linking macroeconomic variables such as GDP growth and temperature changes to credit infections and the probability of default. Our findings reveal that rising temperatures significantly increase financial vulnerabilities, leading to a notable degradation of asset quality and an increase in default likelihood. Due to its reliance on water-intensive processes, the textile sector is particularly prone to climate-induced disruptions, resulting in higher default risks. These results highlight the importance of integrating climate risk assessments into banking practices, focusing on sector-specific strategies to enhance financial stability.