The Impact of Climate Change on Monetary Policy: Modeling Environmental Transition Risks on the Stability of the European Banking Sector (2015-2023)

Abstract

This study investigates the intricate relationship between climate change-induced transition risks and European banking sector stability from 2015 to 2023, examining how environmental factors influence monetary policy transmission mechanisms. Using a comprehensive dataset of 150 major European banks across 19 countries, we employ a multi-stage econometric approach combining Vector Autoregression (VAR) models, stress testing frameworks, and machine learning algorithms to quantify transition risk impacts. Our findings reveal that banks with higher exposure to carbon-intensive sectors experienced significant deterioration in key performance indicators, with an average 12.3% increase in non-performing loans and 8.7% reduction in return on equity during periods of stringent climate policy implementation. The study demonstrates that transition risks create asymmetric effects across banking portfolios, with commercial real estate and energy sector exposures showing the highest vulnerability coefficients (β = 0.847, p < 0.001). Furthermore, we establish that central bank climate policies exhibit non-linear transmission effects, with threshold values identified at carbon intensity levels exceeding 500 tCO2e per million euros of lending. The research contributes to the growing literature on green finance by providing empirical evidence of climate-monetary policy nexus and offers practical insights for regulatory frameworks. Our stress testing scenarios indicate that under accelerated transition pathways, European banks may face aggregate capital shortfalls of €45-67 billion by 2030. These findings have profound implications for monetary policy design, banking supervision, and the broader financial stability architecture in the context of Europe's climate transition objectives.