Journal Article

Disaggregated Liquidity Response to Climate Risk: A Precautionary Hoarding and Flight-to-Safety Perspective

Yahya, Farzan, Hussain, Muhammad, Yu, Wanzhen, Umar, Muhammad

2025

Overview

While financial institutions grapple with mounting climate risks, their impact reverberates differently across the multifaceted dimensions of bank liquidity. Using a panel dataset of 166 countries (1999–2021) and employing two-stage instrumental variable least squares with Driscoll-Kraay standard errors, we examine how climate risk affects asset, funding, market, and systematic liquidity. Drawing upon precautionary liquidity hoarding and flight-to-safety theory, we find that climate risk adversely affects all liquidity dimensions except asset liquidity, as investors seek safer assets during environmental uncertainty. Our subsample analysis reveals that institutional characteristics significantly influence these effects: large and profitable banks benefit from flight-to-safety in funding liquidity despite systemic vulnerabilities, while smaller banks face heightened market and asset liquidity risks due to resource constraints. The impact varies across economic development levels, with low-income countries experiencing more severe systematic and funding liquidity challenges, while high-income countries show greater market liquidity vulnerability. This study advances the literature by providing the first comprehensive multi-dimensional analysis of climate risk-liquidity relationships, offering a nuanced theoretical framework that reconciles conflicting predictions across different liquidity types. Practically and policy-wise, our findings inform size-specific risk management strategies for financial institutions and underscore the necessity for differentiated regulatory approaches, including country-specific capital requirements and climate-adjusted stress testing that reflects heterogeneous impacts across bank sizes and economic development levels. JEL Classification : Q54, G21, C23 Effect of Climate Risk on Various Dimensions of Liquidity Climate risk impacts bank liquidity differently across various dimensions. Our study shows that when climate risk increases, investors seek safer assets, affecting most liquidity types except asset liquidity. Bank characteristics matter: large, profitable banks actually gain funding liquidity during environmental uncertainty, while smaller banks face increased market and asset liquidity risks due to limited resources. Economic development also plays a role - low-income countries experience worse systematic and funding liquidity problems, while high-income countries see greater market liquidity vulnerability. These findings suggest that regulators need tailored approaches to address climate-related banking challenges rather than one-size-fits-all solutions.

• Publisher: SAGE Publishing