The Reserve Bank says climate change is a risk to financial stability. It is proposing to regulate accordingly. A recent paper by the Federal Reserve Bank of New York finds weather disasters are profitable for large banks because they increase loans. In view of the apparent gulf in the two positions, and the lack of any credible evidence so far from the Reserve Bank for its position, the Bank needs to reconcile the gap between its position and the evidence.

Yesterday, I sent the following email to the Reserve Bank. It includes a promise to OIA the Bank at the end of February with a goal of finding out what the Bank has done with these papers:

From: Matt Burgess
Sent: Thursday, 18 November 2021 6:20 pm
To: xxxxxxxxxxxx@rbnz.govt.nz
Subject: Research on climate change and financial stability

Dear xxxxxxxx

In view the Reserve Bank’s interest in climate change, I attach a paper from the Federal Reserve Bank of New York titled “How Bad Are Weather Disasters for Banks?”

Here is the abstract:

Not very. We find that weather disasters over the last quarter century had insignificant or small effects on U.S. banks’ performance. This stability seems endogenous rather than a mere reflection of federal aid. Disasters increase loan demand, which offsets losses and actually boosts profits at larger banks. Local banks tend to avoid mortgage lending where floods are more common than official flood maps would predict, suggesting that local knowledge may also mitigate disaster impacts.[my emphasis]

The paper includes a literature review:

Our main findings are generally consistent with the few papers that study the bank stability effects of disaster. Looking across countries, Klomp (2014) finds that disasters do not effect default risk of banks in developed countries. Brei et al. (2019) find that hurricanes (the most destructive weather disaster) do not significantly weaken Caribbean banks. Koetter et al. (2019) finds increased lending and profits at German banks exposed to flooding along the Elbe River. The study closest to ours by Noth and Schuewer (2018) finds default risk increases at U.S. banks following disasters but the effects are small and short-lived. Barth et al. (2019) find higher profits and interest spreads at U.S. banks after disasters but did not look at bank risk. Based on four case studies of extreme disasters and small banks, FDIC (2005) concluded that …”historically, natural disasters did not appear to have a significant negative impact on bank performance.”

These findings appear to be directly relevant to and substantially at-odds with the Reserve Bank’s position on the financial stability effects of climate change. I have found no record of any of these papers on the Reserve Bank’s web site.

Here are the references to those cited papers with their abstracts:

Barth, J., Y. Sun, and S. Zhang (2019). Banks and natural disasters. SSRN Working Paper

Natural disasters are not rare and costless events. Indeed, the evidence indicates there has been an acceleration in the number of disasters and the associated costs over the past century. Such disasters can cause severe property damage in the communities affected. Typically, insurance policies and government disaster relief fail to cover the full amount of damages. In this case, banks can play an important supporting role in providing additional funding for the necessary reconstruction that takes place after disasters. We provide evidence that following natural disasters, banks with branches in the affected areas raise both deposit and loan rates, but the latter more than the former so that net interest margin increases. This, in turn, leads to an increase in return on assets for such banks, but not sufficiently large enough to indicate profiteering. At the same time, banks increase the use of brokered deposits after natural disasters to help fund the increased demand for loans by individuals and firms in affected communities. Thus banks located in the disaster-prone areas contribute to helping communities recover from natural disasters.

Brei, M., P. Mohan, and E. Strobl (2019). The impact of natural disasters on the banking sector: Evidence from hurricane strikes in the Caribbean. The Quarterly Review of Economics and Finance 72. https://ideas.repec.org/a/eee/quaeco/v72y2019icp232-239.html

While natural disasters cause considerable damage and a number of studies have attempted to investigate the nature and quantify the magnitude of these losses, there is a paucity of empirical evidence on the impact on the banking sector. In this paper we construct a panel of quarterly banking data and historical losses due to hurricane strikes for islands in the Eastern Caribbean to econometrically investigate the impact of these natural disasters on the banking industry. Our results suggest that, following a hurricane strike, banks face deposit withdrawals and experience a negative funding shock to which they respond by reducing the supply of lending and by drawing on liquid assets. There are no signs of deterioration in loan defaults and bank capital. Therefore, the withdrawal and use of deposits rather than an expansion in credit appears to play a significant role in funding post hurricane recovery in the region. This points to the importance of an active reserve requirement policy.

Klomp, J. (2014). Financial fragility and natural disasters: An empirical analysis. Journal of Financial Stability 13 https://doi.org/10.1016/j.jfs.2014.06.001

Using data for more than 160 countries in the period 1997 to 2010, we explore the impact of large-scale natural disasters on the distance-to-default of commercial banks. The financial consequences of natural catastrophes may stress and threaten the existence of a bank by adversely affecting their solvency. After extensive testing for the sensitivity of the results, our main findings suggest that natural disasters increase the likelihood of a banks’ default. More precisely, we conclude that geophysical and meteorological disasters reduce the distance-todefault the most due to their widespread damage caused. In addition, the impact of a natural disaster depends on the size and scope of the catastrophe, the rigorousness of financial regulation and supervision, and the level of financial and economic development of a particular country.

Koetter, M., F. Noth, and O. Rehbein (2019). Borrowers under water! Rare disasters, regional banks, and recovery lending. Journal of Financial Intermediation Forthcoming. https://libkey.io/10.1016/j.jfi.2019.01.003?utm_source=ideas

We show that local banks provide corporate recovery lending to firms affected by adverse regional macro shocks. Banks that reside in counties unaffected by the natural disaster that we specify as macro shock increase lending to firms inside affected counties by 3%. Firms domiciled in flooded counties, in turn, increase corporate borrowing by 16% if they are connected to banks in unaffected counties. We find no indication that recovery lending entails excessive risk-taking or rent-seeking. However, within the group of shock-exposed banks, those without access to geographically more diversified interbank markets exhibit more credit risk and less equity capital.

Noth, F. and U. Schuewer (2018). Natural disaster and bank stability: Evidence from the U.S. financial system. SAFE Working Paper 167.

Our analysis provides new evidence that weather-related disaster damages in the banks’ business regions indeed weaken bank stability and performance. This is reflected in significantly lower bank z-scores, higher probabilities of default, higher non-performing assets ratios, higher foreclosure ratios, lower return on assets and lower equity ratios in the two years following a natural disaster. For a relatively small number of (non-weather-related) geological disasters in the United States, such as earthquakes and tsunamis, we show that these disasters have even relatively stronger adverse effects on bank stability. Overall, the evidence reveals that natural disasters jeopardize borrowers’ financial solvency and decrease bank stability, despite potential insurance payments and public aid programs. On a more positive note, we find that banks generally manage to recover from the adverse shock from weather related disasters (but not from geological disasters) after some years, which is reflected in the bank stability and performance measures of affected banks that are not significantly worse than those of unaffected banks two or three years after a disaster.

Given the extent of the apparent gap between these research findings and the Reserve Bank’s position on the financial stability effects of climate change, I trust the Reserve Bank will consider this research seriously and be able to reconcile its position with these findings.

Given the public interest in this area and the significant steps the Reserve Bank is considering around disclosure and possibly other regulation, at the end of February 2022 we will submit a request to the Reserve Bank under the OIA for all documents and emails which refer to these articles.

I hope you will find this research interesting and useful.

Best regards,

Matt Burgess

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And a reminder that none of those five papers appear anywhere on the Reserve Bank web site, according to Google on 17 November, despite their obvious relevance to the relationship between climate change and financial stability. #smh

The Reserve Bank keeps saying climate change threatens financial stability. It has been saying that for three years. No previous Reserve Bank Governor agrees, judging by their silence on the matter. As I said in last week’s report on the Reserve Bank, after three years of looking the Reserve Bank has not been able to come up with any evidence for their theory. I’m sure it is due any minute now.

Via John Cochrane, the Federal Reserve Bank of New York has taken a different approach. It has actually looked at the evidence. Its paper, called “How Bad Are Weather Disasters for Banks?” includes this as its opening sentence in the abstract: “Not very.”

It goes on:

Disasters increase loan demand, which offsets losses and actually boosts profits at larger banks. Local banks tend to avoid mortgage lending where floods are more common than official flood maps would predict, suggesting that local knowledge may also mitigate disaster impacts.

Here is their literature review:

Our main findings are generally consistent with the few papers that study the bank stability effects of disaster. Looking across countries, Klomp (2014) finds that disasters do not effect default risk of banks in developed countries. Brei et al. (2019) find that hurricanes (the most destructive weather disaster) do not significantly weaken Caribbean banks. Koetter et al. (2019) finds increased lending and profits at German banks exposed to flooding along the Elbe River. The study closest to ours by Noth and Schuewer (2018) finds default risk increases at U.S. banks following disasters but the effects are small and short-lived. Barth et al. (2019) find higher profits and interest spreads at U.S. banks after disasters but did not look at bank risk. Based on four case studies of extreme disasters and small banks, FDIC (2005) concluded that …”historically, natural disasters did not appear to have a significant negative I impact on bank performance.”

So, a small, short lived increase in default (not stability) risk, followed by higher profits as a result of higher lending for the recovery. Larger banks see the greatest boost in profitability.

Oh.

There is more substance in that quote above than anything the Reserve Bank has written on climate change. Look at this tripe, from their the Reserve Bank’s Climate Changed report:

A key concern for us is the exposure of the financial sector, including banks and insurers, to climate-related risks… We take our role seriously, so in 2018 we launched our Climate Change Strategy to understand and manage our direct impacts on climate change, incorporate climate change into our core functions, and lead through collaboration…  Without significant action there will be serious impacts on our economies.

There is more that we can collectively do to integrate climate considerations throughout the financial system. It is encouraging to see national and global progress – for example, progress in setting a framework to disclose climate-related risks and some firms beginning to disclose, the delivery of the Climate Change Commission’s first set of advice, and the launch of Toitū Tahua, the Centre for Sustainable Finance. Internationally we are heartened by collaboration in international groups such as the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and the Sustainable Insurance Forum (SIF), and the focus on finance at this year’s United Nations Climate Change Conference (COP26).

A key challenge is that financial stability is best maintained when all relevant risks have been identified, priced and allocated to those best able to manage them. Work is underway to increase our global understanding of these risks.

Yet we need to be realistic in measuring our collective global progress against the scale of the risks before us and the transition required. While tools like disclosure and scenario analysis are critical in helping us understand and prepare for climate risks, we cannot let a desire to perfect such analysis paralyse us…

Etc. The Reserve Bank could have written that literature review quoted earlier. It decided not to. Instead, the Bank chose to pump out its risible agitprop which might as well have come from Greenpeace.

As Cochrane points out:

This is a courageous paper to write… “We looked and there is nothing here” is not going to go down well. It’s hard to publish papers and get jobs as climate and finance researchers these days if you come up with the “wrong” answers.

A reminder that John Cochrane is delivering a public seminar for the New Zealand Initiative on 2 December. You can sign up here.

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Post script: The Fed’s literature review, the part that covers stability, has references to five academic papers. These papers have pertinent titles: “Financial fragility and natural disasters,” “The impact of natural disasters on the banking sector,” “Borrowers under water! rare disasters, regional banks, and recovery lending,” “Natural disaster and bank stability,” and “Banks and natural disasters.”

According to Google, none of those five papers are mentioned anywhere on the Reserve Bank’s web site. Quelle surprise.