How Does Competition Affect Bank Adaptation to Climate Risks?

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.

In their working paper, Bank Competition and Strategic Adaptation to Climate Change, OFR Research Principal Dasol Kim, OFR Quantitative Analyst Luke Olson, and Richmond Federal Reserve Bank Senior Economist Toan Phan, study how banks learn and adapt to emergent risks, such as climate change. Importantly, the authors find evidence that strategic considerations are important in determining banks’ responses, namely those associated with competitive pressures.

Learning about emerging sources of risks with limited prior knowledge and limited historical observations is a well-known and difficult problem. How financial institutions respond and adapt their behavior to information gained is not well understood. Banks face an array of risks when lending to clients, and some of these risks are not well known when originating loans. When a new risk emerges, such as climate-related financial risk, banks can adjust to this risk in various ways. The management of an emergent risk can be complicated because banks learn gradually, and the risk may continue to evolve. At the same time, bank regulators face similar challenges, making it difficult to monitor and supervise a bank’s risk management.

The authors examine these issues using confidential data on internal bank risk models. They “look under the hood” and directly identify learning about climate risks following Hurricane Harvey, a devastating Category 4 hurricane that made landfall in Texas and Louisiana and caused catastrophic flooding in August 2017. They find that banks affected by the disaster are more likely to internalize and subsequently reduce portfolio exposures to future flood risks in areas unaffected by the hurricane. However, local loan competition dampens banks’ responses; the reductions in risky lending disappear when there is more competition in the local loan market. These findings support the view that limited oversight of emerging risks reduces incentives for bank risk management. The authors also find that banks are less likely to reduce their portfolio exposures to climate risks when competitors in the local loan market are also less likely to do so. This suggests a strategic complementarity in climate adaptation by financial institutions.

Many of the regulatory proposals and policy experiments currently being considered around climate risks focus on microprudential considerations: those affecting the safety and soundness of individual banks. This paper highlights the need to also consider macroprudential consequences, as an individual bank’s risk management strategy may spill over onto those of its competitors.