Does Disaster Risk Relate to Banks’ Loan Loss Provision Estimates?

We examine the relation between disaster risk and banks’ loan loss provision (LLP) estimates. We propose a disaster risk measure based on the natural disasters declared as major disasters by the Federal Emergency Management Agency over the past fifteen years. We theoretically support and empirically validate our measure using three different approaches, including the UN Sendai Framework for disaster risk reduction, which relates disaster risk to natural hazard exposure, vulnerability and capacity, and hazard characteristics. Using more than 445,000 bank-quarter observations, we document that banks located in counties with higher disaster risk recognize larger LLP after controlling for other bank-level factors related to LLP estimates. We employ several techniques to ensure the robustness of our findings, including difference-in-differences estimation and matched samples. In additional analysis, we propose three alternative measures of disaster risk, explore the characteristics that better enable banks to recognize disaster risk in their LLP estimates, and investigate the consequences of managing disaster risk through LLP. Our results are important, especially because of the increasing concern about disaster risk and because they inform the growing debate on the economic consequences of disaster risk and the ability of the banking system to proactively manage the resulting credit risk through LLPs.