# **1 Introduction**

There is increasing global recognition that climate change, natural disasters and environmental issues can lead to risks for the financial sector. Financial sector authorities are devoting greater attention to understand and quantify such impact in the banking sector (Bank for International Settlements 2020; Network for Greening the Financial System 2020), and global standard-setting bodies have recently issued guidelines for the assessment, management and supervision of such risks for the financial sector, including the Financial Stability Board’s (FSB)’s Roadmap for addressing climate-related financial risks (FSB 2021) and the Basel Committee on Banking Supervision’s (BCBS’s) Principles for the effective management and supervision of climate-related financial risks (BCBS 2022).

There is a need for better understanding the effects of climate change and environmental related natural disasters on financial sector soundness through reliable quantitative estimates. Although there is growing interest in the relationship between climate change and the macroeconomy and financial sector, the economics and finance literature has so far paid limited attention to providing generic quantitative estimates with reasonable certainty on causality. Rigorous empirical evidence on the impact of climate risks on banking sector stability is growing but still relatively scant (Basel Committee on Banking Supervision, 2021). Such quantitative estimates could provide a helpful reference in monitoring, assessing and mitigating these types of risks, such as in climate-related risk assessments and stress testing. This paper seeks to provide such quantitative evidence to fill this gap, focusing on physical risks.

In this paper, we examine the association between such natural disasters and banks’ asset quality. Credit risk may arise because of the direct effect of hazard events on the likelihood of borrowers’ to repay and service debt (income effect). The loss of collateral or, in general, destruction of physical assets diminishes borrowers’ wealth, affecting banks’ ability to fully recover the value of a loan in case of bankruptcy (wealth effect). On the other hand, government intervention, the availability of insurance, financial support by banks or alternative funding sources can keep borrowers afloat, financing the recovery in the aftermath of a natural disaster (Baltas et al., 2021). Therefore, whether natural disasters have a negative impact on banks’ asset quality is an empirical question that we address using aggregate data on bank non-performing loans. We also explore whether the relationship varies depending on economic development, as less developed economies may have fewer resources and shallower financial markets to manage the losses from extreme weather events (Loayza et al., 2012). Finally, we summarize emerging policy recommendations for financial authorities to monitor, assess and manage climate and environmental related physical risks to the banking sector.

Climate and environmentally related financial risks originate mainly from two types of sources. **Physical risks** derive from natural disasters and gradual permanent shifts of the climate that can lead to economic costs and financial losses. These risks directly affect banks, potentially increasing credit, operational, market, liquidity, operational, and reputational risks, threatening the profitability and solvency of banks and the overall stability of the financial system. They can either be gradual in nature, such as rising temperatures and sea levels; or abrupt, as in the case of extreme weather events such as wild fires and storms. **Transition risks** are related to adjustment 2