with country-province-specific hazards. In a second step, we narrow our physical risk assessment to the portion of assets that banks allocate to households for home loan purposes, i.e. mortgages. We therefore combine the flood hazard mapping information with the banking system's outstanding mortgages within each country-province. In a third and final step, we use geographical nonperforming loan (NPL) data at the country-province level and natural disaster information to study possible changes in banks’ asset quality in the aftermath of large-scale natural disasters. Our baseline empirical methodology consists of a difference-in-difference method that exploits quasi-exogenous variations in provinces affected by natural disasters.

We estimate credit risk exposure to transition risks by relying on a sectoral exposure analysis. To obtain a rough measure of LAC banks’ exposure to transition risks, we focus on exposures to highly CO2-intensive and environmentally damaging industries and assets. We focus on industries most affected by transition risks, including fossil fuel and energy production, heavy industry, transportation, agriculture and real estate. Moreover, using firm-level data, we analyze the financial health of LAC firms operating in transition-sensitive sectors.

Our data set is composed by a cross section from 9 countries (Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, and Dominican Republic) for the estimation of physical risks, and from 12 economies (the nine countries cited above excluding Ecuador plus Costa Rica, El Salvador, Paraguay, and Uruguay) for the estimation of transition risks. Our physical risk assessment is complemented by an empirical estimation comprising a panel of 5 countries (Argentina, Brazil, Chile, Mexico, and Peru) over a period of 35 quarters (2011q3 and 2020q1). We take all data from public sources, with data availability determining our sample composition.

Our results are the following. In terms of physical risks, we find that exposures to floods represent the most important source of credit risk for the LAC banking sector. This is compounded by high loan concentration in and around LAC capital cities, which, ceteris paribus, entails higher physical risks to province-specific natural disasters. Using a difference-in-difference method, we present empirical evidence of a significant increase in banks’ NPLs in the aftermath of large-scale natural disasters, with heterogeneous effects across portfolio types. In particular, we find that large-scale natural disasters could trigger an increase in total NPLs of up to 1.4 percentage points in affected provinces. Evidence points to a higher impact on the non-financial corporate loan portfolio. Our results are in line with previous findings and are robust to different estimation strategies.

In terms of transition risks, our results show that banks located in the largest emitter LAC countries (adjusted for the size of their economy) have credit portfolios tilted to transitionsensitive sectors. This is particularly the case for Argentina, Uruguay, Paraguay, and Bolivia, where the agriculture sector takes a lion’s share of greenhouse emissions and as well of banks’ assets. Additionally, pre-pandemic firm-level data shows that firms operating in transitionsensitive sectors already present signs of stress, especially those in the fossil fuel and agriculture industry.

The rest of the paper is organized as follows. Section 2 briefly describes the key characteristics of the LAC banking sector, the economic damage and frequency of natural disasters, and the climate-related and environmental risk regulations for the LAC region. Section 3 presents the data and the methodology employed to estimate banking sector credit risk exposures to physical 4