Climate Change and Financial System Stability: Developing Country’s Perspective

Abstract

The stability of the Financial System is under threat due to climate change. Financial institutions are directly affected due to the systemic risk associated with climate change. Banks on the other hand could exacerbate climate risks owing to their funding of non-friendly environmental products. Using an ARDL estimation method, this study investigates biodiversity loss and financial system stability nexus in a developing country. Banks in developing countries do not actively fund the real sectors of the economy primarily due to the associated risks of those sectors. However, Central banks should incorporate an effective supervisory framework towards mitigating climate risks which may worsen in the long run. This paper examines the interactive effects of climate risk on financial system stability from a developing country’s perspective. The author adopted the Pesaran et al., (2001) autoregressive distributed lag (ARDL) bounds test approach to cointegration in estimating the study. We established a long-run relation in the variables of interest. The study validated the stability of the estimation model with the CUSUM and CUSUM of square tests. Our results show that carbon emission does not constitute non-performing loans in Nigeria. Again, bank lending till this period of investigation is not a driver of climate risk in the country.  The findings may be true in the short- run, however, the dynamics of our findings may change in the long run. Hence, regulators should seriously consider mitigating climate -related risks to financial stability like in other jurisdictions. International collaboration is needed. Regulators must adopt active supervisory roles and regulatory frame work to mitigate climate risk. Banks should be enhanced with climate preparedness. Banks should begin to disclose publicly their risks to climate change as well as their ability to manage such. Environmental factors should receive the necessary attention. The need to incorporate climate action policy into the financial system to ensure stability is the major contribution of this study. Banks do not actively lend to the real sector and are not conscious of environmental issues that might worsen climate risks.