Climate and ESG-Related Risks in Banking: Implications for Economic Resilience in Developing Economies

The research paper explores the role of the risks associated with climate and the social, environmental, and governance practices adopted by banks in developing economies on banking stability and economic resilience. With climate change causing more and more physical risks and transition risks, credit, market, and capital adequacy vulnerability are even more prone to financial institutions. Based on a dynamic panel regression model of commercial banks in third world countries between the years 2010 and 2024, the paper presents an estimation framework of System Generalized Method of Moments (System GMM) which solves the endogeneity and persistence of financial stability indicators. The measurement of climate risk is based on composite physical and transition risk indices, whereas the measurement of ESG performance on standardized ESG scores and sub-components is made. Climate stress-testing simulations based on scenarios is used to complement the analysis to determine the effect of forward-looking capital adequacy. The results show that risks posed by climate have considerable impacts on the stability of the bank, rise in non-performing loans, and increased vulnerability. Nevertheless, excellent ESG performance cushions such negative impacts, making the company more resilient to climate and macroeconomic shock. The moderating effect has also been found to be influential in nations where the institutional structures are stronger. The findings emphasize the need to incorporate ESG in risk management and regulatory compliance in enhancing sustainable financial resilience of developing economies. Core Contribution: This article contributes to the literature in sustainable finance and financial stability in three different ways, it constructs a coherent empirical model that incorporates climate-related risks and ESG performance directly related to banking stability implications. Whereas other previous studies tend to study the dimensions in isolation, the current research designs the interaction of the two to show that ESG practices mediate climate risk exposure. It offers solid cross-country panel results of developing economies, which is underrepresented in the climate-finance literature. The study identifies structural discrepancies in resilience dynamics in the face of institutional constraint, sectoral concentration, and greater resilience to climate shocks than in advanced markets by concentrating on the economies that have institutional restrictions, sectoral concentration, and greater exposure to climate shocks. The paper provides policy-proposed suggestions based on empirical findings, such as integration of climate stress-testing, standardization of ESG disclosures and capital strategies allocation as part of sustainable financial resilience. The study is theoretically and practically relevant in terms of adding to the current discourse on climate risk management in banking systems as it fills the gap in empirical analysis and regulatory implications.