How Do Floods Affect Banks' Financial Conditions? Evidence from Japan

This paper investigates the impact of flood disasters on banks' financial conditions. Using granular, municipality-level data from Japan, we exploit exogenous variation in the timing and location of floods to identify how the effects of these flood events are transmitted to banks' balance sheets. We find that flood exposure impairs asset quality and profitability, evidenced by elevated non-performing loan ratios and credit cost ratios alongside reduced returns on assets. However, the estimated magnitudes of the impairments are economically small relative to their average level, suggesting that the impact of floods on banks' financial conditions has been quantitatively limited thus far. Simultaneously, banks expand credit supply in affected regions following floods, possibly reflecting heightened credit demand of firms and households, driven by reconstruction and liquidity needs. In addition, we observe that the responses of variables are heterogeneous: banks exposed to regions where land prices decline sharply following floods experience larger declines in financial performance and a more muted expansion of credit. These observations are further pronounced for banks with a high proportion of their total lending secured by real estate. Our findings suggest that the depreciation of collateral value can also be an important transmission channel of climate-related physical risks to the banking sector.