Chart 2 Exposure concentration and insurance as a mitigating factor  Sources: AnaCredit, 427 data, EMDAT, OECD and ECB calculations. Notes: Left panel: credit exposures to non-financial corporations (NFCs) above € are considered; € trillion of exposures overall; NFC location used to assign risk levels refers to the corporations’ headquarters; country breakdown refers to the bank’s country of residence. Right panel: sample includes 45 countries for which the OECD provides quarterly GDP data from 1996 to 2019. The chart shows the impact of large-scale natural disasters (i.e. with total damage larger than the third quartile at 0.1% of GDP) when the share of insured losses is high (above the median of 35%) on the left, and low (i.e. below the median of 35%) on the right. The estimates are obtained using a panel regression model where the dependent variable is the year-on-year difference in the log of GDP and the explanatory variables include two dummies capturing large-scale disasters with a high and low share of insured losses respectively (included with up to three lags), and country and quarterly fixed effects. For the quarter including the date(s) of the disaster (t=0) and the three subsequent quarters, the y-axis measures the percentage point impact of the disaster on the year-on-year annual growth rate at the end of that quarter. In principle, one mitigating factor may be insurance, which in the past has helped support aggregate demand and hastened reconstruction following disasters, reducing the overall impact on economic activity (Chart 2, right panel).

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.