Climate transition risk raises bank funding costs in repo market

Banks with greater exposure to climate transition risk, measured by their financed emissions, consistently incur higher borrowing costs in the European repo market.

A one standard deviation increase in financed emissions leads to repo rates that are 7–12 percent higher on average.

This 'carbon premium' is a combination of a genuine risk premium, compensating lenders for increased credit risk, and an 'inconvenience premium,' reflecting the sustainability preferences of dealer banks.

The study utilized transaction-level data from 2019–2022, combining repo borrowing information with banks' financed greenhouse gas emissions to establish this link.

The carbon premium in repo rates significantly amplifies during periods of market stress, tripling in size.

This interaction suggests that climate risks heighten existing financial vulnerabilities, contributing to systemic risk.

Transition risks also alter monetary policy transmission: borrowing rates for 'brown' banks (those with high financed emissions) adjust approximately 7 percent faster to new policy rates during hikes than for 'green' banks.

This indicates an uneven pass-through of central bank policy across the banking sector, potentially hindering the effectiveness of monetary policy measures.