Consequences of Adverse Shocks on Bank Behavior

Topic & Objectives

Empirical data show that natural disasters, which have the potential to devastate entire regions and to cause loss of life and property, have become even more frequent and destructive over the last decades. Policy-makers worldwide worry that this may also have negative effects on financial stability and have thus started initiatives to analyze and mitigate consequences for the financial sector.

SAFE Working Paper No. 167

This paper explores whether natural disasters affect bank stability. On the one hand, this seems to be obvious as disaster damages immediately reduce banks' collateral values and the credit standing of their borrowers. Further, disaster damages may cause business disruptions and adversely affect economic growth in the banks' business regions. On the other hand, insurance payments as well as public financial aid programs support corporations and individuals in affected regions, and thereby mitigate the shock. Reconstruction activities may even boost economic growth.

The paper’s analysis is based on a comprehensive dataset of over 13,000 reported disaster damages in the United States and yearly financial data for over 6,000 banks over the period 1994 to 2012, resulting in over 66,000 bank-year observations. The dataset thereby allows to explore a large variation in disaster damages across regions, banks and time.

Key Findings

• Disaster damages in the banks' business regions indeed weaken bank stability and performance. This is reflected in significantly lower bank z-scores (a measure of bank stability), higher probabilities of default, higher non-performing assets ratios, higher foreclosure ratios, lower returns on assets and lower equity ratios in the two years following a natural disaster.
• This evidence reveals that natural disasters jeopardize borrowers' financial solvency and decrease bank stability, despite potential insurance payments and public aid programs.
• On the positive side, banks manage to recover from the adverse shock after some years if no further disasters occur in the meantime.
  
  

SAFE Working Paper No. 94

This paper analyses how banks react to catastrophic events. From a policy perspective, it would be desirable that banks continue to provide financing to borrowers, but that they also maintain their stability in an unfavorable market environment that is adversely affecting their asset quality. Previous research shows that banks reduce lending in the wake of a crisis, but little is known how banks' business decisions affect bank stability during such times, and how this is related to their lending.

The paper uses Hurricane Katrina and two contemporary hurricanes in 2005 as a natural experiment which exposed banks' borrowers to enormous losses and thereby diminished banks' asset quality. Our main interest is to explore banks’ adjustments of risk-based capital ratios because they are a key determinant of bank stability and a cornerstone of banking regulation. Further, we are interested in bank lending to non-financial firms.

Key Findings

• Banks that are located in the disaster areas and are not part of a bank holding company increase their risk-based capital ratios after the hurricane. They thereby strengthen their buffer against future income shocks and mitigate bankruptcy risks.
• Affected banks that belong to a bank holding company do not increase their risk-based capital ratios. They seem to rely on internal capital markets and financial support within their holding structure.
• The effect on independent banks mainly comes from the subgroup of high capitalized banks. These banks increase their holdings in government securities and reduce loans to non-financial firms.
• The results of the paper contribute to a better understanding on how banks navigate through crises and, given the renewed attention and importance of capital requirements for financial stability, are relevant for ongoing reforms of the banking sector.