# **1. Introduction**

There is growing global recognition that climate change, natural disasters and environmental degradation can lead to risks for the financial sector (see, for example, NGFS 2020a). Climaterelated and environmental risks originate from two types of sources: (i) physical risks, which emanate from natural disasters and global warming, and can lead to economic costs and financial losses; and (ii) transition risks, which are related to economic adjustment costs during the transition towards a greener, carbon-neutral economy. Both physical and transition risks can affect credit, operational, market and liquidity risks, threatening the profitability and solvency of banks and potentially the stability of the financial system.

While at the conceptual level there is broad agreement on the transmission channels through which climate-related and environmental risks can morph into financial risks, there is a need to better understand the interplay between climate-related and environmental risks and the financial sector and to quantify financial risks. Although there is growing interest in the relationship between climate change and the financial sector, the empirical literature has only recently started to pay attention to providing quantitative estimates with reasonable certainty on causality. Reliable quantitative estimates could be helpful for assessing, mitigating and monitoring climate-related and environmental risks for the financial sector. In this context, this paper attempts to provide a first and preliminary estimation of climate-related and environmental risks for the commercial banking sector in a sample of economies in Latin America and the Caribbean (LAC).

Several studies have investigated the effects of physical risks on the banking sector. Noth and Schüwer (2018) find evidence that weather-related natural disasters significantly weaken the stability of US banks with business activities in affected regions. In particular, within two years after the disaster banks' z-scores decrease, probabilities of default increase, non-performing asset ratios and foreclosure ratios increase, and returns on assets and equity ratios decrease. These effects are economically significant. Similarly, Barth et al. (2019) study the impact of natural disasters on overall bank performance in the US during 2000-2017 and find that the occurrence of natural disasters impacts banks’ liquidity, especially at smaller banks. Regelink et al (2017) model the impact of severe flood scenarios on mortgages, commercial real estate, and SME loan portfolios of Dutch banks, predicting substantive financial losses. Empirical evidence also points to credit rationing in disaster-prone areas. For instance, Faiella and Natoli (2019) find that, regardless of credit demand factors and disaster insurance coverage, the amount of loans granted to firms in Italy is negatively correlated to their climate risk exposure.

For a sample of 160 countries during 1997-2010, Klomp (2014) finds that weather-related and other natural disasters increase the likelihood of a bank’s default in emerging economies. In the LAC region, Brei et al. (2019) document that following a hurricane strike, banks in the Eastern Caribbean face deposit withdrawals and negative funding shock to which they respond by reducing the supply of lending and by drawing on liquid assets. However, the authors do not find signs of deterioration in loan defaults and bank capital. Berg and Schrader (2012) study volcanic eruptions in Ecuador and show that credit demand increases after a disaster strikes, while the probability of loan approval decreases, although being a repeat client provides some advantage.

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