Does disaster risk relate to banks' loan loss provisions?

Published in European Accounting Review

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Natural disasters have a tremendous economic and social impact, inflicting severe damage to property and infrastructure, devastating local economies, and potentially harming national economic output. These events are difficult to predict and can be classified as shocks to the financial system. Recently, the Federal Reserve Board has emphasized the impact of natural disasters on financial stability, mainly on financial institutions' ability to identify, measure, and monitor disaster risk.

From the financial risk management perspective, two critical characteristics distinguish disaster risk from other types of risk. First, disaster risk impacts all sectors and asset classes, albeit with different intensities. Second, insurance services and public assistance programs provide insufficient coverage against disaster risk. These characteristics imply that disaster risk cannot be avoided entirely but only mitigated.

Disaster risk could be concentrated on banks' lending portfolios and, if not correctly managed, could create a systemic risk to financial stability. Disaster risk faced by borrowers could be transferred to banks' lending portfolios through the reduced ability of borrowers to repay loans due to disaster-related financial constraints. This translates into an increase in credit risk for banks, which could also lead to higher liquidity risk because of the reduction of cash inflows.

Banks must incorporate disaster risk into their risk management strategies to avoid creating a systemic risk to financial stability. One approach for banks to manage disaster risk is using disaster risk financing tools, such as incorporating the risk in their lending decisions on a loan-by-loan basis. However, another practical approach is recognizing higher loan loss provisions, the bank's largest accrual, to build reserves for possible future write-offs in the current period. By utilizing more effective credit risk models, managers can increase current loan loss provisions to accelerate the recognition of potential future bad debts that otherwise must be recognized in subsequent periods.

We examine the relationship between disaster risk and loan loss provisions for a sample of non-interstate US commercial banks from 2002 to 2019. We measure disaster risk by assessing the variation in the number of natural disasters declared as major disasters by the Federal Emergency Management Agency (FEMA) over a 15-year span for each U.S. county quarter.

We find that disaster risk positively relates to loan loss provisions. Specifically, one standard deviation change in disaster risk is associated with a change in loan loss provisions ranging between +5.4% and +7.0%, which results in a reduction in earnings of 1.2% to 1.6%.

To strengthen identification and facilitate causal interpretation, we conducted an event study using Hurricane Katrina as a shock that induced banks to reprice disaster risk in loan loss provisions for banks in counties previously affected by hurricane events but not directly impacted by Hurricane Katrina. Since we omit banks in counties that Hurricane Katrina directly impacted, the increase in loan loss provisions can be attributed to the repricing of disaster risk rather than to the direct effects of losses from hurricane damage.

Prior literature shows mostly ex-post economic consequences of natural disasters. We contribute to this line of research by examining whether banks proactively manage credit risk by making adequate loan loss provisions to recognize disaster risk that impacts lending portfolios. We contribute to this line of research by identifying disaster risk as an important environmental determinant of a bank's largest accrual.

Our study also has important implications for the debate on the supervision of the risk associated with natural disasters in the financial system. Our findings suggest that banks generally incorporate disaster risk in their loan loss provisions and that these provisions are more related to future charge-offs.

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Authors at the Department of Management

 Lorenzo Dal Maso – Associate Professor Financial Analysis

Academic disciplines: Financial Accounting, Banking Industry.

Teaching areas: Financial Analysis, International Accounting.

Research fields:  International Accounting, Financial Analysis, Equity Valuation

Lorenzo is an Associate Professor of Financial Analysis and International Accounting. He is also Adjunct Financial Accounting Professor at the Bologna Business School. He worked as an Assistant Professor at the Erasmus School of Economics Rotterdam and ESSEC Business School Paris. He was a visiting professor at the Business School of Edinburgh and Bauer College (University of Houston). His research interests are mostly on the impact of ESG activities on companies' valuation. He is the Director of the Master of Science in Economics, Consultancy & Accounting.