Capital resilience in the carbon era: bank efficiency and physical risk interaction in high-income and middle-income countries

In an era with heightened financial uncertainty and an increase in climate risk shocks, the capital level of banks has become one of the crucial tools to increase depositor trust and promote long-term stability while remaining resilient. The study investigates the capital decision of Islamic and conventional banks across High-Income and Middle-Income countries over a period of 28 years. The study further examines the relationship between cost efficiency and bank capital across different level of physical risk exposure. The estimation using random effect model of cluster standard errors discloses a significantly positive relationship between transition risk, profitability, and economy with the capital level. Meanwhile, cost efficiency and bank size are negatively correlated with the capital level. The capital level of banks is found to be significantly different between crises and non-crisis periods, between bank specializations, and between country groups. Additionally, the findings reveal that physical risk negatively moderates the relationship between cost efficiency and bank capital, with the interaction effect being more pronounced for banks operating in high physical risk environments. Regulators are recommended to ensure both Islamic and conventional banks consistently uphold high capital level while implementing stricter monitoring on larger bank size to mitigate moral hazard.