Does Directed Lending Affect Climate-Induced Bank Risk? Evidence From India

Abstract

This study examines how climate change affects bank risk and investigates the roles of Priority Sector Lending (PSL) and diversification in shaping banks’ vulnerability and resilience in an emerging economy using an unbalanced panel of 80 Indian commercial banks over the period 2005–2020. We construct a composite climate change index based on temperature and precipitation anomalies to capture persistent climate stress. Bank risk is measured using ΔCoVaR, which reflects banks’ contribution to systemic downside risk, and the Z-score, which captures financial stability and distance-to-default. The analysis employs bank- and year-fixed-effects regressions to evaluate the direct and moderating effects of climate change and PSL on bank risk, respectively, as well as the moderating role of diversification. The results show that climate change significantly increases bank risk by raising ΔCoVaR and reducing Z-scores. PSL independently elevates bank risk and further amplifies the adverse impact of climate change, suggesting that directed lending to climate-sensitive sectors intensifies financial vulnerability. Heterogeneity analysis reveals that public sector banks are the most vulnerable to the combined effects of climate stress and PSL exposure, although similar amplification effects are observed among private and foreign banks. In contrast, both income and asset diversification reduce bank risk and weaken the transmission of climate shocks by lowering tail-risk exposure and strengthening financial stability. The findings identify directed lending as an amplifier of climate-related risks within the banking system and highlight diversification as an effective mechanism for enhancing banking sector resilience.