This paper examines the intersection of climate-induced shocks, financial frictions, and systemic risk transmission in Barbados, a small island economy heavily reliant on a bank-centric financial system. It explores how climate shocks exacerbate non-performing loans (NPLs), intensify financial instability, and impede economic recovery. By integrating financial stability theory and climate finance, this study highlights the persistence of credit supply constraints in Barbados, driven by risk-averse banking behavior, path-dependent lending, and macroeconomic rigidities. The research demonstrates that extreme climate events disproportionately amplify systemic risk, with a nonlinear relationship between capital destruction and financial stress. Using a comprehensive macro-financial stress-testing framework, the study assesses the impact of climate-induced capital loss on capital adequacy and credit supply, revealing significant vulnerabilities in the financial system. The findings challenge conventional credit cycle models by showing that supply-side constraints dominate over demand-driven factors. The paper also discusses the role of regulatory frameworks, suggesting the need for climate-adjusted stress testing, improved provisioning mechanisms, and enhanced financial resilience policies to safeguard economic stability. The study offers a roadmap for policymakers to strengthen the financial system’s resilience to climate risks and improve capital allocation for long-term productivity growth.
Jakubík et al. (Sun,) studied this question.