Climate-induced Transition Risk and Financial Stability: The Role of National Governance Quality

Abstract

With the economic growth of economies becoming more based on a low-carbon growth strategy, climate-induced transition risk (CTR) has become an ever-increasing factor of global financial instability. Such transition processes are most drawn democratic to the emerging economies where the financial systems are still highly exposed to the carbon-intensive industries and institutional adaptive capabilities are yet to be developed. On this note, the current study aims at examining how CTR influences financial stability among the seven emerging economies (E7) using a panel dataset between 2009 and 2021. By using a fixed-effects regression model, the findings indicate that CTR has significantly undermined financial stability reflecting heightened exposure of banking systems to policy, regulatory, and market adjustments associated with the low-carbon transition. Notably, the results indicate that this negative impact is largely mitigated by high quality of national governance (High_NQG ), advocating that sound institutional structures in the form of policy credibility, regulatory effectiveness, and accountability are effective in ensuring that the transmission of CTR to the financial system is contained. To overcome the possible endogeneity issues and enhance causal inference, the study uses a Two-Stage Least Squares (2SLS) model, and the findings are consistent with the initial estimates. At the end of the study, the implications in practical and policy are discussed