As regards negative interest rates, although there is no conclusive evidence to date that they have adversely affected the supply of bank credit, we cannot rule out that maintaining rates at very low levels for an additional, potentially extended, period of time, could ultimately have some negative consequences for the bank-based transmission of monetary policy. In this regard, the mitigating measures adopted by the ECB, consisting of a tiered system for remunerating excess liquidity holdings, are intended to soften the negative impact on bank profitability of the new reduction in reserve remuneration, and thus ensure the expansionary effect on activity and inflation of any additional cuts to interest rates in the current setting. 2. Banking sector profitability This is the economic environment that banks, economic agents and, in particular, financial institutions will face in coming years. If I may, I will now move on to analyse the developments in Spanish banking sector profitability and the determinants thereof. Profitability is one of the main variables that characterise the financial position of banks and it provides the first line of defence against adverse shocks. Indeed, the volume of a bank’s profits determines the return its owners can earn on the capital invested. This, duly adjusted for the risks assumed, will affect the bank’s valuation. Moreover, profit levels determine the margin these agents have available to address shocks. Indeed, low profitability reduces the possibility of generating capital internally through retained earnings.

As we have seen in the pandemic, a common shock can have asymmetric impacts on countries which have a high concentration of certain sectors, such as tourism. Perhaps more importantly from a financial integration perspective, interconnectedness through supply chains matters. Take manufacturing, which accounts for around 20% of banks’ loan portfolios. While the reported direct emissions of these companies are comparatively lower, indirect exposures through the supply chain are more substantial. The physical risks of climate change have a clearer geographic angle and differ in their regional impact. These risks are also expected to increase in the coming decades, with some likely to be concentrated in particular geographical areas. Floods are the most significant hazard in central and northern Europe, for example, while heatwaves, droughts and wildfires represent the greatest risks in southern Europe. Taken together, around 30% of the credit exposures of euro area banks are to businesses with high or increasing exposure to at least one source of physical risk. Ultimately, the impact of climate change on financial stability depends on the degree of concentration of exposures, and what mitigation measures are in place. Both fronts give cause for concern. Over 70% of identified physical risk exposures in the euro area are held by just 25 banks. There is also a notable concentration by country (Chart 2, left panel), suggesting that physical risk could become a prominent source of asymmetric shocks. Moreover, the physical collateral backing loans may itself be damaged by the event, exacerbating the risk to banks.