Financial stability shocks tend to be more severe if shocks are abrupt and unexpected, while gradual losses allow banks to better manage and adjust their portfolios. Nonetheless, the World Bank study does not provide the economic impact distribution across the projection period, a key input for estimating the potential impact on the banking sector. To deal with this limitation, we undertook two exercises. In a first scenario, we assumed that the full impact on GDP growth of a collapse in ecosystem services occurs by the end of the projection period. In a second exercise, we assumed that half of the impact occurs by the end of the projection period. These exercises rely on an assumption of abrupt ecosystem shifts on the back of biodiversity degradation. These assumptions are in line with Lovejoy and Nobre (2018), who point out that a loss of just 20-25 percent of the remaining biome in the Amazon basin could trigger an ecosystem regime shift.<sup>16</sup> The link with the banking sector is made through the historical relationship between banks’ loan quality and GDP growth. Borrowers’ repayment capacity tends to deteriorate under weaker macroeconomic conditions. Empirical evidence documents a negative relationship between bank NPLs and GDP growth (see, for example, Balgova, Plekhanov and Skrzypinska 2017; <u>Ghosh 2015;</u> and Beck and Jakubik 2013). For Brazil, GDP growth also stands out as a relevant driver of NPLs, as documented, among others, by Vazquez, Tabak, and Souto (2012) and <u>Chang and others (2008). Based on historical sensitivity of NPLs to GDP growth in Brazil, we provide indicative</u> estimations on the variation in NPLs associated with drops in GDP as a result of a collapse in ecosystem services. Given the limited knowledge on all potential channels that could lead to an impact on the banking sector, our estimate should be considered conservative.

# **Transition risks**

# _Activities in biodiversity hotspots_

Banks run transition risks when they provide financing to companies that are prone to require a costly adjustment towards a more sustainable economy. One clear example of such firms is presented by those that operate in protected or valuable areas. According to Dasgupta (2021), much of global biodiversity lies outside current protected areas. The materialization of these risks would entail the government designating new areas as protected areas and/or tightening environmental regulations, which would force firms operating in the area to adapt or even relocate, imposing costs to the companies involved. Therefore, the starting point of this analysis relies on the identification of areas that are currently protected. Then we identify valuable areas that could become protected in the near future based, among others, on their biodiversity richness. Third, we estimate the banks’ loan allocation for all Brazilian formal firms and their establishments, also factoring in geographic information. As a final step, we summarize all the information obtained to estimate potential loan allocation in biodiversity hotspots at the municipality level.

> 16 According to current WWF estimates, around 17 percent of the Amazon forest has been lost in the last 50 years. See https://www.worldwildlife.org/threats/deforestation-and-forest-degradation.

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