Climate risk and financial stability in the network of banks and investment funds

•Study effects on financial stability of climate transition risk and market conditions.•Extend the climate stress-test framework to the network of banks and investment funds.•Derive analytical results to identify key drivers for climate transition risk.•Application to a unique supervisory dataset (Mexico) in a wide range of scenarios.•Strong market conditions allow to reach ambitious climate targets at low risk level. We analyze the effects on financial stability of the interplay between climate transition risk and market conditions, such as recovery rate and asset price volatility. To this end, we extend the framework of the climate stress-test of the financial system by including an ex-ante network valuation of financial assets which accounts for asset price volatility as well as for endogenous recovery rate on interbank assets. Moreover, we also consider the dynamics of indirect contagion of banks and investment funds, which are key players in the low carbon transition, via exposures to the same asset classes. We derive some analytical results and we apply the model to a unique supervisory dataset in a range of climate policy scenarios and market conditions. In the event of a disorderly low-carbon transition, stronger market conditions allow to reach more ambitious climate policies at the same level of financial risk.