On the Role of the European Banking Sector in Mitigating Climate Change

ABSTRACT We explore the role of the European banking sector in mitigating climate change through five transmission channels: (1) Banking Sector; (2) Environmental; (3) Economic; (4) Social and (5) Governance, considering both the direct and indirect effects. Utilising bank‐level data from 2010 to 2023, covering 77 banks under the Single Supervisory Mechanism (SSM) across 19 EU countries, we identify key drivers influencing carbon footprint. Direct effects through the banking sector channel reveal that the carbon footprint of bank loans, NPL ratio, bank capital to asset and loan disbursements contribute to carbon footprint, while bank regulatory capital to risk‐weighted assets, green bonds and return on assets reduce it. Bank capital and return on assets emerge as pivotal factors since they can be utilised in driving eco‐friendly investments. Regarding the indirect effects, through the environmental channel, energy consumption contributes to carbon footprint, while environmental protection investments of the total economy and renewable energy consumption reduce it. Through the economic channel, economic growth (GDP) and consumption of goods and services increase the carbon footprint. In the social channel, income inequality also contributes to the carbon footprint. Finally, the strength of the legal rights index, operating through the governance channel, reduces the carbon footprint.