ESG Governance and Probability of Default: The Role of Climate Risk Management in Banking

In the aftermath of the financial crisis, regulatory bodies and policymakers have highlighted the importance of strong regulatory frameworks for tracking and addressing risks within the financial system. In parallel, attention has grown on Environmental, Social, and Governance (ESG) issues, particularly on climate change and climate risk, besides the traditional risk assessment requirements. Regulators such as the European Banking Authority (EBA) have urged including ESG in risk management and disclosure practices to ultimately increase financial stability. In particular, sustainability performance is relevant as it can address climate-related physical and transition risks that directly impact banking system stability. Our objective in this chapter is to test whether banks with active board oversight of climate change risks exhibit lower default risk metrics. Using a sample of 178 European banks during the 2014–2023 timeframe and a mix of market-based and balance sheet metrics, we study the effect of climate risk management and board oversight on idiosyncratic risk at market values and, comparing ‘climate change aware’ and ‘climate change unaware’ banks, we test the effect of their environmental behavior on the probability of default. Our results have implications for banks and policymakers, as strong environmental performance, in the presence of active board oversight of climate change risks, may improve banks’ resilience. These findings highlight the need for policymakers to promote regulatory environments that support sustainability while also ensuring financial stability and addressing climate change in the long run.