Natural disaster risk and bank management: a new perspective on loan loss reserves

November 29, 2023 4 min read

Natural disasters, with their devastating impact on local economies and infrastructure, pose a critical challenge to the global financial system. 

A recent study published in the European Accounting Review, titled “Does disaster risk relate to banks’ loan loss provisions?” breaks new ground in understanding how banks manage the risk associated with these unpredictable events.

Lorenzo Dal Maso, Associate Professor of Financial Analysis at the University of Bologna – along with co-authors Professors Francesco Mazzi (University of Florence), Kanagaretnam Giri (Schulich School of Business, York University) and Gerald Lobo (University of Houston, Houston) – performs an in-depth analysis of banks’ loan loss provisions in relation to natural disaster risks. The study is based on a sample of non-interstate commercial banks in the United States, from 2002 to 2019, and measures climate risk as a function of the number of natural disasters, available in the Federal Emergency Management Agency database, that occurred at the county level in a given quarter.

The findings are surprising: there is a positive correlation between climate risk and loan loss provisions. Specifically, a one standard deviation increase in climate risk is associated with an increase in loan loss provisions between +5.4 percent and +7.0 percent, thus leading to a reduction in earnings between 1.2 percent and 1.6 percent. 

To strengthen identification and facilitate causal interpretation, a study of events is conducted using Hurricane Katrina as a shock that caused banks to reevaluate disaster risk in loan loss provisions. The observed increase in provisions can thus be attributed to the revaluation of disaster risk rather than the direct effects of hurricane losses.

This study not only contributes to the existing literature on post-disaster economic consequences, but also offers a new perspective on how banks proactively manage credit risk by adjusting loan loss provisions to recognize the risk that impacts loan portfolios in the event of a disaster. The implications are also significant with regard to the general debate on the supervision of risk associated with natural disasters in the financial system. Indeed, the conclusions suggest that banks generally already incorporate disaster risk into their loan loss provisions and that they are of higher quality. 

This article is based on
Does Disaster Risk Relate to Banks’ Loan Loss Provisions?
European Accounting Review