Bank Competition and Strategic Adaptation to Climate Change

Banks face an array of risks when lending to clients, some of which are not well known when a bank originates a loan. When a new risk emerges or a risk’s importance increases, banks mitigate these risks by adjusting their lending behavior (Working Paper 24-03).

Abstract

How does competition affect banks’ adaptation to emergent risks for which there is limited supervisory oversight? The analysis matches detailed supervisory data on home equity lines of credit with high resolution flood projections to identify climate risks. Following Hurricane Harvey, banks updated their internal risk models to better reflect flood risk projections, even in areas unaffected by the disaster. These updates are only detected in banks with exposures to the disaster, indicating heterogeneous bank learning. We use this heterogeneity to identify how bank adaptation is affected by competition. Exposed banks reduce lending to areas with higher flood risks, but only in less competitive markets, suggesting that competition fosters risk-taking over risk mitigation. Additionally, banks are less likely to adapt in markets where competitors are also less likely to do so, suggesting a strategic complementarity in bank adaptation. More broadly, our paper sheds light on the role of competitive forces in how banks manage emerging risks and relevant supervisory challenges.

Keywords: Banks, climate risk, real estate, natural disasters, competition, moral hazard
JEL Classifications: D14, E6, G21, Q54

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