Abstract

Addressing climate change stands out as a pivotal challenge of the twenty-first century, demanding the development of a robust environmental policy framework. This study explores the relationship between environmental policy and the default risk associated with financial institutions in European Union nations from 2006 to 2022. We show that the loan-to-deposit ratio, an indicator of bank default risk, is negatively associated with the climate change performance index (CCPI) and macroeconomic factors. Companies with higher CO2 emissions were associated with increased credit risk following the Paris Agreement event, due to potential future climate regulatory changes. Moreover, the climate change performance has a significant adverse impact on variations in credit risk variations under this event. These results are due to climate regulations, which become applicable and effective over time. Overall, these findings indicate that climate change policy affects the banks’ credit risk and that banks with higher default risk are negatively correlated with this index. This highlights the crucial role that financial regulators and policymakers have in directing financial institutions toward the adoption of risk assessment practices aimed at ensuring financial stability and promoting environmentally sustainable practices.