Climate change and the rise of shadow banking: A global analysis

Abstract

Climate change is a growing challenge for global economic stability, with significant implications for financial sector development. This study examines the relationship between climate vulnerability and the growth and structure of financial systems across a global sample of 29 countries. Using panel data, we find a positive relationship between climate risks and the overall size of financial systems, but the effects of climate change vary across financial subsectors. While climate vulnerability is associated with a decline in traditional banking assets, it is positively linked to the expansion of shadow banking activities. This shift suggests a compensatory dynamic, where financial activities migrate from heavily regulated traditional banks to less-regulated shadow banks in response to heightened climate risks. This finding is robust even when we focus only on the bank-like shadow banking sector, modify the estimation strategy, or include a vast array of control variables. Our analysis also shows that these effects are most pronounced in developed countries, where institutional environments play a key role in mediating these relationships. Strong governance indicators, including rule of law and government effectiveness, mitigate the adverse impacts of climate risks on traditional banks, while greater public accountability and transparency discourage excessive shadow banking growth. These findings underscore the urgent need for more regulatory scrutiny beyond the confines of traditional banking to enhance financial stability.