Climate risk is changing where banks lend - before disaster strikes
UNSW Sydney
Key Facts:Data from the US suggests banks are already responding to physical climate risk before a disaster hits – with consequences for small businesses and local economies.
Whether buying a home or opening a local business, affordability is no longer the only question people should be asking, says Associate Professor Kristle Romero Cortes. They should also consider what their property might look like in 10 or 20 years.
“Whether or not it will be underwater or on fire,” she says.
As a finance researcher at the UNSW Sydney Business School and Senior Deputy Director of the UNSW Institute for Climate Risk & Response, A/Prof. Romero Cortes says climate change is increasingly a financial problem.
She is the co-author of a new study suggesting banks adjust their behaviour in anticipation of physical climate risk – before storms, floods or fires translate into financial losses.
“The finance side of climate risk isn't just ‘disaster happens, then bank suffers’,” A/Prof. Romero Cortes says.
“It's priced in ahead of time, which is also how it ends up reshaping who can borrow and where.”
Measuring risk before a disaster
Much of the existing research into climate change and banking starts after a disaster. After a storm hits, properties are destroyed, businesses close and borrowers struggle to repay loans. Researchers examine what happened to banks and lending afterwards.
A/Prof. Romero Cortes and her co-authors instead used temperature records from across the United States (US) to develop a measure of what economists call systematic physical climate risk – broad changes in climate conditions that affect many places at once, making the risk difficult to avoid simply by spreading investments geographically.
The measure was created from temperature data alone – not records of hurricanes, floods, fires or the financial losses they caused.
The researchers then tested whether those patterns predicted subsequent disasters. The results showed counties more exposed to broad temperature shifts subsequently experienced more disasters and greater damage.
This allowed the team to connect changes in the physical climate with financial risk before losses had occurred. They could then examine how exposed individual banks were to those risks and what they did in response.
“The banks with greater exposure to physical climate risk held more capital and altered their lending behaviour,” A/Prof. Romero Cortes says.
A shift away from exposure
While climate change itself is global, its physical risks aren’t evenly distributed. A/Prof. Romero Cortes says there are substantial geographic differences in how local temperatures deviated from historical norms. Patterns were related to factors including latitude, longitude and proximity to the coast.
Areas more exposed to these temperature shifts experienced a higher likelihood of major disasters and greater damages.
“Rather than cutting credit everywhere, they shifted it away from places that were more exposed to the same climate risks,” she says.
For a county with the median level of climate exposure in the study, a one-unit increase in a bank's physical climate risk measure was associated with about 10% fewer small-business loans and a 5% fall in the value of lending.
“For an average bank-county pair in the study, that was about five fewer loans and US$130,000 less small-business lending each year,” A/Prof. Romero Cortes says.
The effect only intensified when climate shocks then occurred.
Insurance is another way climate risk can affect access to finance. While the study did not directly examine insurance premiums, the researchers compared different banks lending into the same US county in the same year, which allowed them to account for the local conditions that affect all borrowers.
The method helped isolate the changes in lending associated with a bank’s own exposure to physical climate risk.
“Insurance seems important, but really, it applies to everyone equally,” A/Prof. Romero Cortes says.
“In our study, insurance doesn’t affect a bank's decision as they are weighing the risk of repayment, not the insurability of any specific property.”
A rational decision, another problem
For a bank, moving money away from areas with increasing physical climate risk seems rational. Collectively, however, those decisions could leave climate-exposed communities with less access to the finance they need to adapt and grow.
Small businesses are usually riskier borrowers, A/Prof. Romero Cortes says. If banks decide that lending in climate-exposed regions adds too much risk to their portfolios, then they simply put their money somewhere else.
“They could just exit the market, at which point those small businesses don't get funded,” she says.
“But if you don't have any small-business lending, you don't have the lifeblood of a local economy, which is what helps an area prosper and flourish.”
A bank can move its money. A local café, manufacturer or agricultural business can't necessarily move with it.
“You wouldn't think that no risk is necessarily a good thing. But we do need to have some risk.”
What does this mean for Australia?
The research is based entirely on the US, and A/Prof. Romero Cortes says the numbers can’t be transferred across to Australia – because the banking systems are very different.
The US has thousands of banks operating across a vast and geographically varied market. Regional banks operate in only a handful of states, and even the larger institutions have different geographic footprints.
The geographic variation gives US banks more opportunity to diversify. Australian banking, by contrast, is much more concentrated.
The four major banks operate across many of the same markets. If a major physical climate risk affects Sydney, for example, it is unlikely to be neatly contained within the portfolio of one institution.
“The risks that affect Sydney will affect all big four banks – because they all operate in Sydney,” A/Prof. Romero Cortes says.
Australian banks can still diversify between different kinds of lending and assets, she says. Their portfolios aren't identical – some have greater exposure to institutional, residential or other forms of finance. But, unlike the US, their shared geographic footprint means a major climate shock could affect all four simultaneously.
While the study does not examine whether Australian banks are already restricting small-business lending in climate-exposed locations, A/Prof. Romero Cortes says the mechanism identified in the US raises questions about how physical climate risk could flow through to Australia's much more concentrated banking system.
Whether it's a family choosing where to buy a home, an insurer setting a premium, a bank deciding where to lend, or a small business trying to expand, “climate is baked into everything at this point, whether we study it specifically or not,” A/Prof. Romero Cortes says.
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Melissa Lyne
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