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What is a Climate Bad Bank and Why Does Europe Need One?
As Europe races to meet its legally binding net zero target by 2050 (European Climate Law), the financial sector faces a looming climate risk — the potential for stranded assets tied to fossil fuels. These assets, currently sitting on bank balance sheets, could rapidly lose value as economies transition away from carbon-intensive industries. If left unmanaged, this could trigger a ‘green swan’ financial crisis, a concept first introduced by the Bank for International Settlements (BIS) in its seminal 2020 Green Swan Report (BIS 2020).
Green Swan Risks: Climate Change as a Financial Stability Threat
The European Central Bank (ECB) reinforced these concerns in its 2024 Climate Stress Test Report, which found that a substantial portion of euro area bank loans remain misaligned with the goals of the Paris Agreement. With climate risks accelerating — from record floods in Spain (The Guardian) to California’s devastating wildfires (NASA Earth Observatory) — it is clear that climate is no longer just an environmental issue, but a material financial threat.
The Climate-Driven Polycrisis and Its Impact on Banking
The ECB’s climate stress test concluded that, even under baseline scenarios, climate-related loan losses could amount to significant capital depletion for many banks (ECB Climate Stress Test 2024). If a disorderly transition occurs — where climate policy accelerates abruptly after years of insufficient action — combined with an economic downturn, these losses could rival those seen during the Global Financial Crisis of 2008 (European Commission State Aid Report), which triggered EUR 1.5 trillion in state aid for European banks.
The European Climate Law and Its Financial Consequences
The European Climate Law legally commits all EU Member States to net zero emissions by 2050. This means that every sector — from heavy industry to financial services — must align with this target. According to the ECB’s 2024 Supervisory Review, European banks continue to finance high-carbon assets, exposing themselves to major climate transition risks.
Why Conventional Tools Won’t Be Enough to Manage Climate Financial Risk
At the Green Swan 2024 Conference (Green Swan 2024), economists and central bankers stressed that traditional monetary policy tools — such as interest rate adjustments — are not fit to handle climate-driven systemic risks. Climate transition involves:
- Higher energy prices during the shift from fossil fuels to renewables.
- Temporary productivity losses in carbon-heavy sectors.
- Inflation volatility due to fluctuating carbon prices.
The ECB has acknowledged this challenge in its Monetary Policy Statement 2024, warning that inflation targeting will need to account for climate-induced supply shocks.
Learning from History: How Bad Banks Helped in Past Financial Crises
Europe already has extensive experience using bad banks to manage financial crises. In the early 1990s, Sweden created Securum, a state-backed bad bank, to resolve its real estate crisis (Sveriges Riksbank History). Similar mechanisms were used during the Eurozone Debt Crisis (European Stability Mechanism Case Study), when bad banks helped stabilize the banking sectors in Ireland and Spain.
A Climate Bad Bank — More Than Just Risk Management
A climate bad bank would go further than traditional bad banks. Its dual role would be:
- Isolating high-carbon stranded assets, shielding the banking system from climate-driven credit losses.
- Accelerating decarbonization by actively winding down fossil fuel assets in line with the EU’s climate targets, while redirecting capital into clean energy and green technologies.
This aligns directly with the EU Sustainable Finance Taxonomy, ensuring all actions comply with Paris Agreement objectives.
How Would a Climate Bad Bank Work in Practice?
The climate bad bank could operate as a public-private partnership, combining:
- Public capital from the European Investment Bank (EIB).
- Crisis-response tools from the European Stability Mechanism (ESM).
- Private sector co-investment from institutional investors who recognize the economic logic of orderly decarbonization.
This model would mirror the European Bank Resolution Framework (SRB Framework), ensuring taxpayer protection while aligning financial flows with net zero.
Can the EU Build Political Consensus for a Climate Bad Bank?
The biggest obstacle is political. Some governments, particularly in fossil fuel-heavy economies, might resist such intervention — fearing it could encourage moral hazard or lead to uneven burdens across Member States. This debate mirrors earlier divisions over the EU Recovery Fund.
To overcome this, the climate bad bank must feature:
- Clear governance rules.
- Strict climate alignment criteria for asset purchases.
- Robust private sector co-financing to limit taxpayer risk.
Why Policymakers Must Act Before the Next Climate Financial Crisis Hits
The window to prevent a green swan financial crisis is closing fast. Delaying action means higher economic costs, greater financial instability, and missed opportunities to lead global sustainable finance. Policymakers need systemic tools, not just incremental tweaks, to manage this polycrisis.
A climate bad bank — backed by public-private cooperation and anchored in EU climate law — could offer the best chance to safeguard Europe’s financial system while ensuring a just and orderly transition to net zero.
Get Ahead: Join Our Certified ESG Practitioner Program
Now you have the chance to understand how innovative financial mechanisms like climate bad banks can mitigate climate-related financial risks while supporting the net zero transition. Attend our upcoming Europe – Asia | Certified Sustainability (ESG) Practitioner Program, on May 22-23 & 26, 2025 to gain the latest tools and strategies to navigate ESG regulations and drive sustainable finance solutions in an era of permacrisis.
