Spotlight on physical risk: Assessing the banks' stock reaction to the ECB climate stress test

Using an event study approach, this paper examines the impact of the ECB's 2022 climate stress test on the share prices of European banks. We provide novel evidence that investors reacted negatively to both the announcement of the stress test and the publication of the results, even though there was no direct impact on regulatory capital and no detailed disclosure for individual institutions. Our unique dataset combines granular information on bank branch locations with geospatial data on several physical risks (landslides, floods and extreme temperatures) and shows that banks with branches in areas most exposed to physical risks had lower abnormal returns relative to their peers. We also examine the role of being signatory of the Principles for Responsible Banking, finding different results for the announcement and the results' disclosure dates. These results show that investors are pricing in both banks' physical risk exposure and their commitment to responsible banking, even though the regulatory framework for climate risk management is still evolving. Our findings have important implications for investors in assessing climate-related risks in their portfolios, for banks that should develop strategies to manage and mitigate these risks, not only to meet regulatory requirements, but also to preserve their market value and stakeholders' trust, as well as for policymakers in designing effective climate risk disclosure and management frameworks for the banking sector.