How Climate Transition Risk Is Quietly Reshaping Bank Liquidity and Repo Market Pricing

The paper shows that banks with greater exposure to carbon-intensive borrowers already pay higher costs for short-term funding in Europe’s repo market, even though these transactions are secured and traditionally seen as risk-free. Climate transition risk therefore amplifies financial stress and creates uneven monetary policy transmission, making it a present-day concern for financial stability rather than a distant threat.

Researchers from the European Central Bank and the Saïd Business School at the University of Oxford examine whether climate change is already affecting how banks fund themselves day to day. Their answer is striking: climate transition risk is now shaping borrowing costs in Europe’s interbank repo market, one of the safest and most important parts of the financial system. Banks that finance more carbon-intensive firms are paying more to borrow cash, even in very short-term, fully collateralised transactions. This shows that climate risk is no longer just a long-term concern for investors; it has entered the core machinery of banking.

Why the repo market matters

The repo market is where banks borrow cash against collateral, often overnight or for a few days. It is essential for managing liquidity and is the main channel through which the ECB’s policy interest rates are transmitted to the banking system. Because repo loans are short-term and secured, they are usually seen as almost risk-free. Using detailed transaction-level data from 2019 to 2022, covering more than two million repo trades among Europe’s largest banks, the authors show that this assumption no longer holds. Climate exposure now plays a role in determining who pays more and who pays less for liquidity.

The carbon premium in borrowing costs

The key finding of the paper is the existence of a “carbon premium” in repo rates. Banks are ranked by their “financed emissions,” meaning the greenhouse gas emissions of the companies they lend to. Banks with higher financed emissions consistently face higher repo borrowing rates. A one standard deviation increase in financed emissions leads to repo rates that are about 7–12 percent higher compared to similar transactions. This result holds even after controlling for collateral quality, maturity, transaction size, balance-sheet strength, and long-standing relationships between lenders and borrowers. In other words, climate exposure itself is being priced.

What drives this premium

The authors explore several reasons for this pattern. One explanation is credit risk. Firms exposed to higher carbon prices and stricter climate policies face rising costs and lower profits, which increases the risk for banks lending to them. Other banks respond by charging higher rates, even for secured short-term loans. A second explanation is demand: carbon-intensive firms may need more funding, pushing their banks to borrow more in the repo market. A third explanation focuses on preferences. Many large European banks have signed voluntary climate commitments, such as the Net-Zero Banking Alliance, and may be less willing to provide cheap funding to banks with high emissions exposure.

The evidence supports a mix of risk and preferences, but not demand. The carbon premium is higher for longer-maturity repos, where counterparty risk matters more, and for repos backed by corporate bonds rather than government debt. Banks with higher emissions are also more likely to face positive haircuts, another sign that lenders see them as riskier. However, these banks do not borrow larger volumes, suggesting that higher rates are not driven by stronger funding demand.

Financial stability and monetary policy effects

The paper shows that climate transition risk also amplifies financial stress. During periods of market turmoil, the carbon premium roughly triples. Banks with highly financed emissions face much higher funding costs precisely when liquidity is most important. Climate risk, therefore, acts as a multiplier of existing vulnerabilities, making stressed situations worse rather than causing problems on its own.

There are also implications for monetary policy. Because the repo market transmits ECB rate changes, uneven pricing matters. The authors find that after ECB rate hikes, banks with higher financed emissions adjust more quickly to higher borrowing costs, while greener banks experience a slower pass-through. This suggests that climate risk and sustainability preferences can subtly distort how evenly monetary policy affects banks across the system.

Overall, the study shows that climate transition risk is already reshaping Europe’s financial system from the inside. It affects the cost of liquidity, increases fragility during stress, and alters monetary policy transmission. Climate change, the authors conclude, is no longer just a future financial risk, it is already influencing the price of money today.